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Dividend Growth, CAPM or APT

Explain the challenge of estimating or coming with a good "feel" for the "cost of equity capital" or the rate of return that you feel your company investors require as the minimum rate of return that they expect of my company (Lowes Companies, Inc.) to earn on their investment in the shares of the company.

Which of the three models (dividend growth, CAPM, or APT) is the best for estimating the required rate of return (or discount rate) of Lowes? Based on your analysis and findings, what would you recommend to the board of directors of for Lowes?

In your paper, include discussion of the following issues:
1. Ease of use of these three models
2. Accuracy of each of these three models
3. How realistic the assumptions of each model are

For this paper I need to take a clear stand and pick one of these three models to defend to the Board of Directors. You cannot tell the Board of Directors that "I like all three models," they want you to come to them with a decisive choice of just one model.

Part II

The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using CAPM model is often more difficult than using the dividend discount model. The companies' financial statements do not show the cost of equity.

The following table shows necessary (hypothetical) information to calculate the cost of equity by using CAPM model:

Company Listing RRF RM BJ

Nike Inc. NYSE: NKE 0.20% 7.50% 0.80

Sony Corporation NYSE: SNE 0.20% 8.50% 1.40

McDonald's Corporation NYSE: MCD 0.20% 9.50% 0.30

E(rj )= RRF + b(RM - RRF)

E(rj ) - The cost of equity

RRF - Risk free rate of return)

Bj - Beta of the security

RM - Return on market portfolio)

Based on the above information, which company has higher cost of equity? Why? Please explain your reasoning in brief.

Solution Preview

1. The dividend growth model, which the expected dividend per share one year from now, the required rate of return for equity investor, and the growth rate in dividends, is the easiest model to use. It assumes a constant growth rate in dividends which can be calculated on the basis of past dividends. The expected rate of dividends is available from different financial websites. Even companies give the expected dividend per share.

The CAPM model uses the beta of the security, the risk free rate of return, and return on market portfolio. Normally, we use the beta of the security given by financial websites. Otherwise, calculating beta can be difficult. The risk free rate and return on market portfolio is also available from the websites. The ease of use of the CAPM model is moderate.

The arbitrage pricing model requires that the factor structure be known and a relationship between the expected rate of return and factor structure should be established. According to the arbitrage pricing model the expected return of an asset is a linear function of the assets sensitivities to n factors. First, identifying each factor, then estimating the risk premium of the factor is difficult. The ease of use of the arbitrage pricing model is very low. ...

Solution Summary

The response provides you a structured explanation of cost of equity capital. It also gives you the relevant references.