CAPM There Are Three Different Models for

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" (Investopedia, 2012). The risk premium is related to the return on the company's stock.

Arbitrage pricing theory is similar, using the same formula but instead of equating risk with the market return on the company's stock vs. The broad market index, the return on the company's stock is compared to a basket of macroeconomic indicators (Pietersz, 2011). These are chosen by the user, and the correlations must be calculated by the user and the weightings of the different indicators also chosen by the user. This contrasts with CAPM, which uses the beta, a correlation statistic that is widely available on the Internet.

This makes CAPM much easier to use, even if APT is more accurate. APT is, however, more arbitrary whereas CAPM's formulation is consistent across companies. The other model, the dividend discount model, derives the cost of equity in a different manner entirely. It is based on the idea that the cost of equity is related to the implied risk premium of the stock, but derives that risk premium from the idea that stock prices are a reflection of current and expected dividends.

Thus, the discount rate is what is left over when the stock price, current dividend and dividend growth rate are taken into account -- any stock price above the implied value of the current dividend and dividend growth rate must be attributed to the risk premium. The major flaw in the dividend discount model is that it simply does not reflect how investors think -- many investors do not price stocks only on the intrinsic value of their dividends and many companies do not even pay dividends.

The latter point is argued away by stating that dividends are expected in the future, which is a hollow argument -- many companies have no intention to pay dividends in the future, which calls into question the viability of the dividend discount model for those companies. With the dividend discount model being excluded for its unrealistic assumptions, we are left with the APT and CAPM as the means of determining the cost of equity.

APT has the benefits of being more accurate and more flexible, but it is much harder to work with. CAPM is relatively accurate, has good fundamental assumptions and perhaps just as important is easy to work with, making it the best choice to determine a company's cost of equity. Part II. Based on the information above, it would be expected that Sony would have the highest cost of capital, because the market return and the beta are both higher.

Using CAPM, we can see that Nike has a cost of equity of 4.09%; Sony has a cost of equity of 9.62% and McDonalds has a cost of equity of 3.3%. Normally, the company with the highest cost.