CAPM There Are Three Models That Can

CAPM There are three models that can be used calculate the cost of capital for the firm. The first such model is the capital asset pricing model (CAPM). The CAPM formula is: E (rj )= RRF + b (RM - RRF). This means that the company's cost of capital is a function of the risk free rate, the market premium and the firm-specific risk. In CAPM, the firm-specific risk is based on the correlation of the company's stock price to the broader market, a statistic known as the beta.

Another method is the dividend growth model. In this model, the assumption is that a stock's value derives solely from the dividends that it is paying, or that investors assume it will pay in the future. It is assumed that investors will not pay for capital gains, because those are uncertain. The formula for the dividend growth model is: source: Investopedia. This model assumes that the price of a stock is based on the current dividend being offered, the growth rate of dividends and the discount rate.

Typically, the stock price is known, and the formula is used to solve for the discount rate, which is the cost of equity. It is assumed that if the company does not currently pay a dividend that it will pay one in the future and this is what investors are using as the basis of determining the stock price.

That assumption is interesting, because there are a number of firms that do not have any intention of paying dividends, yet investors still put their money into these companies, clearly hoping for capita gains. The third method of determining a company's cost of capital is the arbitrage pricing theory. APT is based on the same formula as CAPM, but instead of relating the company's returns to the beta, it relates the company's return to arbitrarily identified macroeconomic indicators.

The user will select the indicators that are believed to be the most important to the company's success -- for example a retailer might be weighed against consumer spending, a small bank against housing starts. The correlation between the company's stock price and the macroeconomic indicators is taken and is then used to determine the level of firm-specific risk to be used in the calculation. Each of these methods has advantages and disadvantages. CAPM and DDM are the easily to use, since they can be calculated with readily-available statistics.

They are also consistent in their formulation. The entire point of APT is that it will be different depending on the person doing the calculation (and determining the indicators used and their weights). This gives that person the opportunity to earn arbitrage profits with his/her superior knowledge of the relationships that drive the company's stock price. CAPM is probably the best for its combination of ease of use and its base assumptions.

DDM is weaker because of the assumption that capital gains are irrelevant -- the stock price of a lot of companies who have no intention of paying dividends is an indicator that investors do buy for capital gains. APT has the most potential, but the analytical skill of the person using it will determine who effective APT is in predicting stock price movements. If APT is used by somebody with keen insight into the industry's drivers, then it should be the most effective.

The popularity of CAPM and DDM derives from their ease of us, not the quality of their assumptions. The assumptions of DDM with respect to capital gains have been discussed, but CAPM's assumption of the ongoing relationship of beta to stock price is also faulty. For many firms, their circumstances can change dramatically based on internal and external characteristics. Certainly the increased liquidity of capital markets and the increased globalization since CAPM was first proposed undermines the strength of the base assumptions about beta.

For example, an investor would be right to ask if Apple will perform in the future as it has in the past, without Steve Jobs. Another example would be a company that has entered into a new market, or made a key acquisition. The pace of change is great in business today, and that undermines the use of historic stock performance as an indicator of future performance.

It could be argued that because APT relies on the same principle, it can be just as inaccurate, but at least with APT the user has the opportunity to identify independent variables that are better indicators of the company's performance than beta. Part II. Using CAPM, we can determine the cost of equity for each of these companies. The cost of equity for Nike is: 4.17%; for Sony it is 9.62%; for McDonald's it is 1.69%.

Nike: Re = 1 + 0.91 (4.49-1) = 1 + 3.17 = 4.17% Sony: Re = 1 + 1.48(6.83-1) = 1 + 8.62% = 9.62% McDonalds: Re = 1 + 0.36(2.94-1) = 1 + 0.69 = 1.69% Sony has by far the highest cost of equity for these three firms. There are two reasons for this. The first is that Sony has the highest beta -- it is the most volatile of these three firms. In this example, Sony also has the highest degree of market risk. Although all three firms are given different levels of market risk, a casual observer.