The Capital asset pricing model provides an alternative approach for the calculation of the cost of equity.
As per the Capital asset pricing model, the required rate of return on equity is given is given by the following relationship: Cost of equity = the risk free rate + (The market risk premium) the beta of the firms share Above equation requires the following three parameters to estimate a firms cost of equity: 1.
The risk free rate 2.
The market risk premium 3.
The beta of the firms 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 yields on long term government bonds as the risk free rate.
You should always use the current risk free rate rather than the historical average.
(2).
the market risk premium The market risk premium is measured as the difference between the long term, historical arithmetic average of market return and the risk free rate.
Some people use a market risk premium based on returns of the most recent years.
This is not a correct procedure since the possibility of measurement errors and variability in the short term, recent data is higher.
As we explained in our previous posts the variability (standard deviation) of the estimate of the market risk premium will reduce when you use long serious of market returns and risk free rates.
(3).
the beta of the firms share Beta is the systematic risk of an ordinary share in relation to the market.
In our previous posts, we have explained the regression methodology for calculating beta for an ordinary share.
The share returns are regressed to the market returns to estimate beta.
Capital Asset Pricing Model VS Dividend Growth Model The dividend growth model approach limited application in practice because of its two assumptions.
1.
It assumes that the dividend per share will grow at a constant rate, g, forever 2.
The expected dividend growth rate, g, should be less than the cost of equity, to arrive at the simple growth formula.
The growth formula is, Cost of equity = (Dividend in year one / Prize in current year) + growth 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 cost of equity, or whose dividend policies are highly volatile.
The dividend growth model approach also fails to deal with risk directly.
In contrast, the Capital asset pricing model has a wider application although it is based on restrictive assumptions.
The only condition for its use is that the companies share is quoted on the stock exchange.
Also, all variables in the Capital asset pricing model 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.
As per the Capital asset pricing model, the required rate of return on equity is given is given by the following relationship: Cost of equity = the risk free rate + (The market risk premium) the beta of the firms share Above equation requires the following three parameters to estimate a firms cost of equity: 1.
The risk free rate 2.
The market risk premium 3.
The beta of the firms 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 yields on long term government bonds as the risk free rate.
You should always use the current risk free rate rather than the historical average.
(2).
the market risk premium The market risk premium is measured as the difference between the long term, historical arithmetic average of market return and the risk free rate.
Some people use a market risk premium based on returns of the most recent years.
This is not a correct procedure since the possibility of measurement errors and variability in the short term, recent data is higher.
As we explained in our previous posts the variability (standard deviation) of the estimate of the market risk premium will reduce when you use long serious of market returns and risk free rates.
(3).
the beta of the firms share Beta is the systematic risk of an ordinary share in relation to the market.
In our previous posts, we have explained the regression methodology for calculating beta for an ordinary share.
The share returns are regressed to the market returns to estimate beta.
Capital Asset Pricing Model VS Dividend Growth Model The dividend growth model approach limited application in practice because of its two assumptions.
1.
It assumes that the dividend per share will grow at a constant rate, g, forever 2.
The expected dividend growth rate, g, should be less than the cost of equity, to arrive at the simple growth formula.
The growth formula is, Cost of equity = (Dividend in year one / Prize in current year) + growth 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 cost of equity, or whose dividend policies are highly volatile.
The dividend growth model approach also fails to deal with risk directly.
In contrast, the Capital asset pricing model has a wider application although it is based on restrictive assumptions.
The only condition for its use is that the companies share is quoted on the stock exchange.
Also, all variables in the Capital asset pricing model 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.