Module C: Risk and Return, Portfolio Diversification and The Capital Asset Pricing Model; The Cost Of Equity

Risk and Return, Portfolio Diversification and The Capital Asset Pricing Model

PART I

Cost of Equity CapitalFeasibility

Dividend Discount Model is the simplest method to determine the cost of equity capital. It is a derivation from Gordon model. It is easy to understand and simple to use. It employs only three inputs to determine the cost of equity; expected dividend amount in the upcoming year, current stock price and expected dividend growth rate (Watson & Head, 2007).

CAPM model is relatively little complex when compare to the Dividend Growth Model. The Capital Asset Pricing Model determines the cost of equity by establishing a linear relationship between required return on investment and its systematic risk. It also required three primary inputs risk-free rate of the return, value of beta for financial asset and average return on the capital market. While risk free rate is easy available, much calculation is the need to get the remaining two variables. Compare to dividend discount model which totally ignores risk, CAPM model also incorporates riskiness of the stock relative to the market while calculating the cost of equity which is a clear advantage over Dividend Discount Model(Megginson, 1996).

Arbitrage Pricing Model is formed more or less above the CAPM model. It is a better model because it employs fewer assumptions as a contrast to Capital Asset Pricing Model which presumes numerous (unrealistic) assumptions. At the same time, APM takes into account number of fair market factors (which often make its calculation complex) when determining cost of equity (www. moneyterms.co.uk).

Reliability

One of the rising concerns of today's market and industry is Risk which affects the company in number of ways. In this regard, dividend growth model is lagging behind because it does not explicitly consider risk. Moreover, it is very sensitive to the values of the growth input variables. It is not capable of considering an extremely unusual market conditions and often result in giving erroneous results. If the growth rate becomes negative, it might be giving negative rate of return of the investor. It ignores market conditions and assumes constant dividend growth for perpetuity (Megginson, 1996).

Contrary to dividend discount model, CAPM takes into account riskiness of the stock relative to the market. This gives it a clear edge over the other model. On the downside, it is depended upon the number of unrealistic assumptions like diversified portfolio and normal distribution of returns. These assumptions are not at all applicable in fair market conditions (Watson & Head, 2007).

Arbitrage Pricing Model divides the factor into macro factors and company specific factors. It is giving, relative to CAPM, more reliable cost of equity. The reliability of the model depends upon on the condition that all the factors are properly identified, and their individual betas accurately determined. It takes into account risk as well those factors which have been ignored by CAPM. The downside of this model is that it involves calculation of the number of betas which makes it extremely hard to determine. If even one beta is calculated wrong, it ...