COST OF CAPITAL

The cost of equity capital and the Capital Asset Pricing Model (CAPM)



Cost of Capital

Introduction

One of the important points of the theory of finance, and one in which researchers in the field are now doomed, is the explanation of returns financial stocks, also called the valuation of assets capital.

A key factor in the valuation of any financial instrument is the implied positive relationship between risk and expected return. Has shown to investors, above all, do not like the risk. As a result, they should be offered additional expected return while higher the expected risk of the securities concerned.

The Dividend growth model approach

The easiest way to estimate the cost of capital common stock is to use the model dividend growth. Many managers use dividend yields as stock selection criteria, selecting those stocks with the highest dividend yield. The logic is simple: get a major dividend, only slightly lower than that of fixed income, and we can get capital gains if the stock goes up. If down not much problem, because we can keep collecting the dividend portfolio, for this is considered a defensive strategy in bear markets itself or people who need regular income from their shares.

Typically, companies that distribute more dividends are usually large companies that grow little, if they could not grow much dividends, since those resources needed to fund new growth projects. This makes their actions are generally very volatile and are not characterized by large gains.

In some cases, investors turn to stock assessment, using a model of constant growth dividend. With this model makes a number of assumptions, including:

- Dividend payments increase each year with the same rate of growth;

- Dividend growth reflects the growth of the company and its assets;

- The required rate of return is always higher than the growth rate of dividends.

In this model, the stock price is determined by the following formula:

Where d0 - the dividend paid in the current year, and K - the required rate of return,%; g - annual growth rate of dividends,%.

For example, the company «ABC» in the current year dividend of 4.255 rubles. per common share. Yearly dividend payments increased by 17.5%. Investor requires a yield of 30%. In this case, the price at which he is willing to buy the shares of the company will be:

This assessment is assessing stocks over the previous model, as investor expectations on the proposed level of dividend and growth rate of the company (dividends) coincide. But the picture may be quite different, if the pace of development of the company will not give the expected size of the dividend. The result of this model may differ from that of the shares received over the previous model.

Disadvantage of this model is that the growth rate of dividend payments does not always reflect the company's growth rate and the dynamics of changes in market prices. In some cases the firm to create the appearance of prosperity, continue to pay high dividends, leaving less of the profit for further development. This leads to the fact that the rate of dividend ...