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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...
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…
Works Cited:
Investopedia. (2012). Capital asset pricing model -- CAPM. Investopedia. Retrieved January 16, 2012 from http://www.investopedia.com/terms/c/capm.asp
Pietersz, G. (2011). Arbitrage pricing theory. MoneyTerms.co.uk. Retrieved January 16, 2012 from http://moneyterms.co.uk/apt/
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