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CAPM vs. DDM vs. APT (General Mills Case Study)

I need help with writing 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 they expect of require my company (General Mills) to earn on their investment in the shares of the company. There are several asset pricing models used to estimate the cost of equity capital for this module in the background materials. After reading through the background materials, write a 5 to 6 pages report for the board of directors for General Mills by responding to the following tasks:

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

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 Ã?j

Nike Inc. NYSE: NKE 0.20% 4.49% 0.79

Sony Corporation NYSE: SNE 0.20% 6.83% 1.98

McDonald's Corporation NYSE: MCD 0.20% 2.94% 0.29

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

E(rj ) - The cost of equity

RRF - Risk free rate of return)

Ã?j - 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

The Capital Asset Pricing Model (CAPM) best serves the function of determining the cost of equity for General Mills Inc (NYSE: GIS). Using CAPM calculations, at $38.24 per share, GIS target security price for February 2013 is $39.57, (Reuters, 2012). If this security price becomes unrealistic within the year, then options to boost investor return through increased dividends should be explored. While less accurate than arbitrage pricing theory (APT) and dividend growth models, CAPM's ease of use, and the isolation of Beta assumptions into a single variable best fit the current state of General Mills Inc.
CAPM would calculate the current cost of equity at 5.96%:
RE= RF + Beta(RM - RF)
RE= 3.15% + 0.18(5%-3.15%)
RE= 3.48%
Expanding the above calculation from left to right, each variable introduces new assumptions, and becomes progressively more contentious. RF comprises the risk-free rate. In this case, the 3.15% yield on a 30-year US Treasury bond is used, (Bloomberg, 2012). Traditionally, RF would use a "zero coupon government bond matching the time horizon of the cash flow being analyzed," (Damodaran, nd). In the assessment for General Mills, however, the time horizon for consideration is flexible. Instead of a 12-month bondâ?"which yields almost zero (0.15%), the coupon on a 30-year Treasury bond represents a more realistic risk-free investment, (Bloomberg, 2012).
Next, and more contentious than RF, is Beta. Beta represents a "statistical analysis of past price movements of an individual stock (against) the market as a whole," (Investopedia, nd). In this calculation, 0.18 was used (Reuters, 2012). While Beta is purported to be a mathematical truth, the assumptions underpinning the concept are extremely fluid. For example, four separate sources were consulted for General Mills' Beta valueâ?"these returned four distinct values ranging from 0.18 to 0.24 (Google Finance, Fidelity, Reuters). The Reuters value was settled on based solely on the reputation of the source. The variance between these Beta values could be due to how each defined the "market as a whole." Just to scratch the surface, they could use: S&P 500 index, Wilshire 5000 index, Dow Jones Total Market Index, or any other infinite number of attempts to capture "the market." Then there is time horizon to consider. Should the entire life of the security be considered when calculating the regression? This, of course, also assumes that "the market" is comprised solely of the stock marketâ?" which further assumes that such stock market is limited to domestic securities of similar risk-adjusted expectations as the target security. In any case, Beta is a powerful variable used in CAPM, with results highly dependent on its selection. In selecting from the limited pool consulted, RE could vary between 3.59% and the settled upon 3.48%.
Lastly for CAPM, and clearly the most precarious assumption, is RM (expected aggregate market return). This represents expectations of the market as a whole across ...

Solution Summary

Uses General Mills Corporation as a case study to illustrate the effectiveness of three valuation models: Capital Asset Pricing Model (CAPM), dividend growth model (DDM), or arbitrage pricing theory (APT).

6 Pages, APA format with references.