The Cost Of Equity Capital And The Capital Asset Pricing Model

1785 words - 7 pages

When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities
This paper will discuss how a manager may decide a minimum acceptable rate of return will be for investors. The three models, dividend growth, CAPM, and APT will be analyzed as to each model’s ease of use and effectiveness and applied to General Mills, Inc. Additionally, some companies’ financial information will be compared using the CAPM model, to determine which company has the higher cost of equity and a conclusion will be made as to the effectiveness of these models.
General Mills, Inc.
The CAPM is the best method of determining the cost of equity for General Mills, inc. (NYSE: GIS). Using CAPM calculations, GIS target for December 2013 is $50.60 (Reuters, 2013). If this security becomes untenable in one year’s time, then the option of increasing dividends to boost investor confidence can be explored. The APT is less accurate compared to the CAPM and the dividend growth models. However, CAPM seems to be the easiest to use. The isolation of the Beta assumptions into a single variable fits the current state of the company best when using the CAPM.
CAPM would estimate General Mills, Inc. cost of equity as follows:
Current cost of equity at 5.96% will be RE=RF+Beta (RM-RF); RE = 3.15% +0.18 (5%-3.15%) = 3.48%
CAPM Variables and Assumptions
When the above calculations are expanded from left to right, new assumptions are introduced by each of these variables. RF represents the risk free rate. In this situation, the 3.15% would use a zero coupon bond matching the time horizon of the cash flow being analyzed (Damodaran, n.d.). In the analysis of General Mills, the time horizon being considered is not static, but dynamic. Instead of a 12-bond, which yields almost zero (0.12%), the coupon on a 30-year Treasury bond represents a better risk-free investment option (Bloomberg, 2012). Hoever, a more contentious variable other than the risk-free rate (RF) is Beta, which is the “A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole” (Investopedia, 2013, para. 1). In this calculation, 0.18 was used. Although Beta is supposed to be a mathematical truth, the assumptions used in the calculations are extremely fluid. For example, several sources were consulted, all which yielded several results. This writer chose to use this particular source for the Beta, Reuters, because of its high credibility. The differences in the Beta values could be based on how each...

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