Note: Sample below may appear distorted but all corresponding word document files contain proper formattingExcerpt from Essay:
There are several different models that can be used to help determine the cost of capital for a company. Each is based on a model, and can be understood not only in terms of its formula but also in terms of its underlying assumptions. These assumptions will provide the foundation for the model, and will inform the financial manager about the strengths and weaknesses of each model. This report will outline in detail three such major models for determining the cost of capital. The first is the capital asset pricing model, known as CAPM. The second is the dividend discount model, and the third is arbitrage pricing theory.
The capital asset pricing model is the first of the three major models for determining the cost of capital. CAPM is widely used to determine the cost of equity in particular. The underlying theory of CAPM is that stock returns relative to risk can be used to determine what cost the market needs for that equity. In short, "investors need to be compensated in two ways: time value of money and risk" (Investopedia, 2013). Thus, the return on a security equates to the risk-free rate of money in the economy, plus a risk premium. The risk premium in the capital asset pricing model is comprised of two elements. The first is the general market risk premium, which is the risk of the market in general above and beyond the risk-free rate. The second component of risk in the capital asset pricing model is the firm-specific risk. For equities, the firm-specific risk is reflected in the beta. The beta is the correlation of the firm's stock price movements in relation to the movements of the market as a whole. Thus, the formula for the capital asset pricing model is as follows:
Source: Investopedia (2013)
The capital asset pricing model is easy to use, because all of the information inputs into the model are easy to come by. The risk free rate is the rate of return on Treasury securities, and the market risk premium is often considered to be around 7% above the risk-free rate. The beta is easy to calculate on a spreadsheet and indeed for all publicly-traded securities is available from any number of financial websites like MSN Moneycentral or Yahoo Finance. The capital asset pricing model is relatively accurate for stocks, but less accurate for determining the cost of bonds, since they do not trade as frequently, and there is no base bond index like there is for stocks and thus no beta. The underlying assumptions of the capital asset pricing model are actually quite reasonable. The cost of equity is the return that investors demand, and the capital asset pricing model directly equates the cost of capital to the returns on the stock.
The dividend discount model argues that while stock returns are important, investors only hold a stock for the known cash flows, that is to say the value of a stock is comprised solely of the present value of expected future cash flows. A key assumption here is that investors do not hold stocks for capital gains, as that would be irrational since all future growth should be priced into the stock. The dividend discount model therefore holds that the cost of capital can be determined by estimating the present value of future cash flows and working backwards from the current stock price. The formula for the dividend discount model is therefore:
source: Investopedia (2013)
While this model is consistent with efficient market hypothesis and therefore explicitly rules out the prospect of speculative investment for capital gains, such a view is at odds with market reality. In truth, many investors hold stocks for the prospect of capital gains. While the dividend discount model takes the view that such investors are really holding the stock for future potential dividends, that is at odds with reality. Some companies expressly state that they do not expect to pay dividends in the foreseeable future yet retain high multiples -- investors are looking for capital gains. While the model can be applied to dividend-heavy, slow-growth stocks, it is entirely inappropriate for companies that do not pay dividends or that are more growth-oriented.
The arbitrage pricing theory is similar in structure to the capital asset pricing model, but seeks to…[continue]
"CAPM There Are Several Different Models That" (2013, September 15) Retrieved October 22, 2016, from http://www.paperdue.com/essay/capm-there-are-everal-different-models-that-96337
"CAPM There Are Several Different Models That" 15 September 2013. Web.22 October. 2016. <http://www.paperdue.com/essay/capm-there-are-everal-different-models-that-96337>
"CAPM There Are Several Different Models That", 15 September 2013, Accessed.22 October. 2016, http://www.paperdue.com/essay/capm-there-are-everal-different-models-that-96337
CAPM There are three different models for estimating the cost of capital -- the capital asset pricing model (CAPM), dividend discount model and arbitrage pricing theory (APT). Of these, CAPM is the best model. CAPM utilizes the returns on the company's stock to calculate the firm's cost of equity. The underlying theory is that the firm's cost of capital should "equal the rate on a risk-free security plus a risk premium"
Capital Asset Pricing Model and Arbitrage Pricing Theory: Capital Asset Pricing Model (CAPM) is an arithmetical theory that describes the relationship between risk and return in a balanced market. The Capital Assets Pricing Model was autonomously and simultaneously developed by William Sharpe, Jan Mossin, and John Litner. The researches of these founders were published in three different and highly respected journal articles between 1964 and 1966. Since its inception, the model
Approximately 19% of the short-term liabilities in the form of notes payable and other short-term debt. The long-term liabilities consist of long-term debt and other miscellaneous liabilities. The debt portion of this represents approximately 39% of the total long-term liabilities. Johnson & Johnson has issued notes onto the market that mature in 2017, comprising the bulk of the long-term debt. The calculate the market value capital structure of JNJ, we need
Popular Cost of Equity Models: Problems and Potentials in Current Theory and Practice It is important for any publicly traded business organization to understand and accurately estimate its cost of equity capital, in order to make effective capital-raising resource allocation decisions. There are several models for determining a supposedly accurate valuation for the current cost of equity capital for a given firm, however each of these models is imperfect in
Valuation There are a number of different factors that contribute to a stock's valuation in the market compared with the financial statements. One fundamental difference between the two is that the book value reflects past performance while the market reflects future performance. Book value of the company's equity is determined by the past profit performance of the stock and the amount of debt that the company has. The market value reflects
RISK Management - CAPM and APT Capital Asset Pricing Model and Arbitrage Pricing Theory The contemporaneous business community is extremely competitive, meaning as such that the organizational leaders strive harder than ever to overcome the competitive forces. Virtually, they have to hire and retain the best skilled staff members; they have to develop and offer the best quality products and services and they must be able to raise the interest of a
Mobile Telephony Cellular service was launched in UK in 1985. Cantel and affiliates of Mobility UK were licenced to operate at 800 MHz. Personal Communications Services (PCS) operating at 1.8 GHz was licenced in UK in December 1995 with two new players, Clearnet and Microcell each receiving 30 MHz of spectrum. Mobility UK affiliates and Cantel each received 10 MHz of new spectrum. PCS service was launched in late 1997. Today,