Dividend Growth Model or the Capital Asset Pricing Model
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Do you feel that the Dividend Growth Model or the Capital Asset pricing Model is more accurate in determine the cost of a firm's common equity? Defend your answer.
Mini Case: After collaborating with people form your finance department, you have completed the analysis of purchasing five new delivery trucks. Using your firm's weighted average cost of capital, it appears that there is not a fleet of trucks that can be purchased that has a positive NPV. Your boss tells you that you should be using the cost of a truck loan (6%) rather than the weighted average cost of capital (14%) to analyze this purchase. By using 6%, even the purchase of Volvo trucks has a positive NPV. Using WACC you can not even justify the purchase of Yugo trucks. What should you tell your boss? How would your response change, if at all, if you were working for a not-for-profit organization? ( this can be another paragraph or 2 thanks)
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Solution Summary
776 words look at a mini case study to determine whether the dividend growth or capital asset model is more accurate for predicting the cost of a firm's common equity.
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Blackboard Discussion Exercise:
Do you feel that the Dividend Growth Model or the Capital Asset pricing Model is more accurate in determine the cost of a firm's common equity? Defend your answer. (this can be 1 to 2 paragraphs)
I feel that the Capital Asset pricing model is more accurate. This is because the dividend-growth approach has limited application in practice :
? It assumes that the dividend per share will grow at a constant rate, g, forever.
? The expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth formula.
? The dividend-growth approach also fails to deal with risk directly.
The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset.
Assumptions of CAPM
? Market efficiency
? Risk aversion and mean-variance optimization
? Homogeneous expectations
? Single time period
? Risk-free rate
Advantage of using CAPM
o This method correlates market return and security return
o This method also takes care of Beta as ...
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