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CAPM and the Constant Dividend Growth Model

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Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a powerful analytical tool used for calculating the price of common stock. After reflecting on theory and application of the CAPM model and reviewing the prior work on the Constant Dividend Growth Model post a one paragraph response to the following questions.
Question 1 - What are the primary advantages and disadvantages of the Capital Asset Pricing Model (CAPM) compared with the Constant Dividend Growth Model for use in pricing common stock?
Question 2 - Can either or both of these two models be used to price the stock of Gamma Inc., a non-publicly traded company that does not pay dividends? Explain your answer.
Question 3 - Why is it that the financial models for calculating the price of a stock cannot be reliably used to make day to day investment decisions in the stock market?

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Capital Asset Pricing Model
Question 1
Unlike the constant dividend growth model (DGM) which assumes that the dividend growth rate is known and stable, capital asset pricing model (CAPM) takes into account the level of systematic risk vis-à-vis the stock market as a whole. Secondly, CAPM eliminates unsystematic risk unlike DGM which assumes that stock price is hypersensitive and that the dividend growth rate cannot be higher than the cost of equity (Thomas & Gup, 2010). DGM ignores market conditions, thus making it easier to compare different companies whereas CAPM uses backward looking market returns which may be inaccurate in predicting future market returns. Additionally, CAPM's primary assumption of borrowing and lending at a risk-free rate makes the minimum required return inaccurate because ...

Solution Summary

This solution presents the advantages and disadvantages of the capital asset pricing model (CAPM) as compared to the constant dividend growth model (DGM). The solution also highlights the suitability of the models in calculating the stock price of non-publicly traded companies and discusses why the financial models for calculating the price of a stock cannot be reliably used to make day to day investment decisions in the stock market.

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CAPM and the Constant Growth Model for IBM


By walking you through a set of financial data for IBM, this assignment will help you better understand how theoretical stock prices are calculated; and how prices may react to market forces such as risk and interest rates. You will use both the CAPM (Capital Asset Pricing Model) and the Constant Growth Model (CGM) to arrive at IBM's stock price. To get started, complete the following steps.
1. Find an estimate of the risk-free rate of interest, krf. To obtain this value, go to Bloomberg.com: Market Data [http://www.bloomberg.com/markets/index.html] and use the CURRENT "U.S. 10-year Treasury" bond rate as the risk-free rate. In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 7.5%.

2. Download this IBM Stock Information document (.pdf file). Please note that the following information contained in this document must be used to complete the subsequent questions.
1. IBM's beta (ß)
2. IBM's current annual dividend
3. IBM's 3-year dividend growth rate (g)
4. Industry P/E
5. IBM's EPS.

3. With the information you now have, use the CAPM to calculate IBM's required rate of return or ks.

4. Use the CGM to find the current stock price for IBM. We will call this the theoretical price or Po.

5. Now use appropriate Web resources to find IBM's CURRENT stock quote, or P. Compare Po and P. Do you see any differences? Can you explain what factors may be at work for such a difference in the two prices? This section is especially important - with more weight in grading - so you may want to do some study before answering such a question. Explain your thoughts clearly.

6. Now assume the market risk premium has increased from 7.5% to 10%; and this increase is due only to the increased risk in the market. In other words, assume krf and stock's beta remains the same for this exercise. What will the new price be? Explain what happened.

7. Recalculate IBM's stock using the P/E ratio model and the needed info found in the IBM pdf file. Explain why the present stock price is different from the price arrived at using CGM (Constant Growth Model).

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