The cost of equity capital and the CAPM
You are asked by your board of directors to write a report explaining 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 that expect of require your company to earn on their investment in the shares of the company. Note that the investment is not the amount shareholders spent buying the share of the company in the past. The true investment is in terms of today's share prices because shareholders COULD have sold their shares today, and if they decided to hang on to these shares instead of selling these shares off this is their true investment in the shares of the company as of today. (This is the correct concept of the opportunity cost to the investors or the shareholders.)
Write a report to the board of directors in the APPLE company in a paper addressing the following issue:
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 you 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.
The company selected is Apple Inc. This is computer hardware/software company based n the USA. It is a multinational corporation and investors from different parts of the world would be interested in investing n the company. The company is well known for its hardware products like Mackintosh computers, the iPod, and the iPhone. The company is seeking to expand into consumer electronics. In the year ended 2008, Apple Inc had a revenue of 32.48 billion dollars. The company has a strong consumer base in the USA and the company enjoys strong brand loyalty among its customers.
There are three methods of estimating the required rate of return of Apple Inc. These are the dividend growth model, the CAPM model and the APT. In the dividend growth model the expected return is yield plus expected growth. This model requires the input of the current dividend rate, the constant growth rate of dividend, and a required rate of return for the stock that remains constant at k which is the cost of equity. The model requires the summing of an infinite series that gives the value of the current price. The arithmetical calculations can easily be carried out , however, the person making the computation must supply the value of g, the constant rate at which D (current rate of dividend) grows. The difficulty in using this model is that the model must be given one perpetual growth rate. This rate varies with the cost of capital from year to year and assigning one growth rate is very difficult. Another difficulty arises if the company does not pay a dividend.
The second model is the capital asset pricing model (CAPM) that is used to determine the appropriate required rate of return of an asset, if that asset is added to an already well-diversified portfolio. So the 'asset's' sensitiveness to market risk must be taken into account. According to the CAPM model the expected excess return on capital asset is the risk-free rate of interest plus beta multiplied by the market premium. The market premium is calculated by subtracting from the expected excess return of the market the risk free rate. The beta co-efficient is the sensitivity of the expected excess asset returns to the expected excess ...
This answer investigates which model - dividend growth, CAPM or APT, is best for estimating Apple's ROR. 1388 words with references.