Capital Asset Pricing Model vs Dividend Growth Model

Topics: Capital asset pricing model, Stock, Risk-free interest rate Pages: 2 (535 words) Published: May 12, 2011
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...
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