Risk And Return Essay

1026 words - 5 pages

Determining the cost of equity and rate of return is an important financial principle. Company shareholders are able to make intelligent decisions when the information is readily available. This paper will describe three specific theories and models that yield the cost of equity. After providing a clear description of all three, I will focus on one particular model, the Capital Asset Pricing Model (CAPM), which is a simplistic approach to cost of equity. Then lastly, the CAPM will be applied to a few companies and discussed.
Three Models
There are several tools available to estimate the rate of return. Three of these tools are capital asset pricing model, the dividend growth model, ...view middle of the document...

Each of these requires a separate beta. The beta of each factor is the sensitivity of the price of the security to that factor.” (Money Terms, 2011) The main focus with this theory is the factors. Unfortunately, because the factors are many and some ambiguous, it may be quite difficult to capture all of the required information. Therefore, this leaves room for inaccuracies which is risky in of itself. The formula used for this particular method is as follows: E(RIBM) = Rf + BIBM,1[R1 - Rf] + BIBM,2[R2- Rf] + BIBM,3[R3 – Rf]. As seen, with each factor, there is an associated beta.
The final method that can be used is the Dividend Discount Model (DDM). The DDM states that “today's price of a share of stock equals the present value of all expected future dividends. Assuming that earnings are expected to grow at a constant rate forever and dividends are a fixed fraction of earnings…” (Investopedia, N.D.) This model is unique in the sense that it can only be used for companies that have dividends which often times ends up being the larger more stable companies.
CAPM, the Method of Choice
After thorough research and evaluation, the method of choice is the CAPM. This method is one that can be used by investors regardless of the size of the company or type of investment. Conversely, both the DDM and arbitrage pricing theory methods rely on certain factors and situations of when they could be used. As mentioned previously, the DDM is restricted to companies that have dividends and tend to be stable. Additionally, it does not truly take into consideration the associated risks. The arbitrage pricing theory, on the other hand, is based on the inclusion of multiple factors such as non-company factors. This theory accounts for consumer spending if applicable to a specific company. This factor can be ambiguous. For this reason, yielding an accurate value is quite difficult. If one portion is missing, the end result will be skewed. Lastly, the...

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