The dividend growth model approach limited application in practice because of its two assumptions. It assumes that the dividend per share will grow at a constant rate, g, forever The expected dividend growth rate, g, should be less than the cost of equity, Ke, to arrive at the simple growth formula.

The growth formula is,

Ke = (DIV1 / Po) + g

These assumptions imply that the dividend growth approach cannot be applied to those companies, which are not paying any dividends, or whose dividend per share is growing at a rate higher than Ke, or whose dividend policies are highly volatile. The dividend growth model approach also fails to deal with risk directly. In contrast, the CAPM has a wider application although it is based on restrictive assumptions. The only condition for its use is that the company’s share is quoted on the stock exchange. Also, all variables in the CAPM are market determined and expect the company specific share price data; they are common to all companies. The value of beta is determined in an objective manner by using sound statistical method. One practical problem with the use of beta, however, is that it does not probably remain stable over time.

The Capital asset pricing model (CAPM) provides an alternative approach for the calculation of the cost of equity. As per the CAPM, the required rate of return on equity is given is given by the following relationship:

Ke = Rf + (Rm – Rf) Bi

Above equation requires the following three parameters to estimate a firm’s cost of equity: The risk free rate (Rf).
The market risk premium (Rm – Rf).
The beta of the firm’s share.

(1). the risk free rate

The yields on the government treasury securities are used as the risk-free rate. You can use returns either on the short term or the long term treasury securities. It is a common practice to use the return on the short term treasury bills as the risk free rate. Since investments are long term decisions, many analysts prefer to use...

...Running head: PRICINGMODELSPricingModels
Adam F. Thornton
FIN 501 – 3
TUI University
Dr. William Anderson
Chipotle Mexican Grill (CMG) is one of the fastest growing restaurant chains in the United States. Self proclaimed as “fast-casual,” CMG offers a dining experience that is unique, organic, and which draws from the local economy. For the investor, CMG is a wise investment for the aggressive and fast growing portion of a portfolio. When determining an appropriate model to evaluate CMG’s potential, the CapitalAssetPricingModel (CAPM) is the best choice. This model offers the best amount detail while maintaining the simplicity needed for a model outlining investment decisions in CMG.
The PricingModels
There are three pricingmodels to discuss when evaluating CMG: dividendgrowth, CAPM, and the Arbitrage Pricing Theory (APT). Each of these models has both advantages and disadvantages, easily tailoring one model to different situations. However, the CAPM is best suited for this case with CMG. Below is a further review on each of models’ advantages and disadvantages, and applicability to CMG’s market position and financial...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three...

...CapitalAssetPricingModel
The CapitalAssetPricingModel otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capitalassetpricingmodel in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller
CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions.
Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market's average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average market rate of...

...Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS)
1. Both the capitalassetpricingmodel and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the CapitalAssetPricingModel and the Arbitrage PricingModel rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have...

... explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
3. In one page explain what you think is the main 'message' of the CapitalAssetPricingModel to corporations and what is the main message of the CAPM to investors?
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an un-diversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial unexpected increase in inflation.
Un-diversifiable risk
The entire...

...CapitalAssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a...

...CAPITALASSETPRICINGMODEL (CAPM) The capitalassetpricingmodel (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below.
CAPM Equation The general formula used for CapitalAssetPricingModel is: re = rf + [ ß (rm - rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm - rf = Market risk (systematic risk) ß (rm - rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk.
CAPM Example Assume there is two Investment portfolio (stocks) or project - A & B. With the information given below, we can use CAPM to help us...

...also found on the balance sheet. The value was $3,494.5 million. Therefore, Joanna found Nike’s debt plus equity to be $4,791.4 million. Dividing the values for debt and equity each by $4,791.4 million gave Joanna the weights to be used in the WACC formula. Debt was weighted as 27% and equity as 73%.
Joanna then proceeded to calculate Nike’s costs of debt and equity. She found Nike’s cost of debt by dividing total interest expense, which was found on the income statement, by her previous calculation for debt. Nike’s total interest expense was $58.7 million, so their cost of debt was found to be 4.3%. Joanna used a tax rate of 38% in her calculations, making Nike’s cost of debt after tax to be 2.7%. Joanna decided to use the CAPM model in her calculation of Nike’s cost of equity. She used the risk-free rate of 5.74% on a 20-year Treasury bond, the geometric mean for market risk premium from 1929 to 1999 which was 5.9%, and Nike’s average beta from 1996 to 2001, which was 0.80 to make her calculations. Using these values, she obtained a cost of equity of 10.5%. Joanna then took the weights and costs of debt and equity that she found and calculated Nike’s WACC to be 8.4%.
Joanna made several errors in her calculation of Nike’s WACC. To begin, she used book values when finding Nike’s debt and equity rather than market values.
If markets are efficient, market values will equal present value of cash flows. Book values, on the other hand, represent...

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