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…