Cost of equity Essay

Cost of equity

CAPITAL ASSET PRICING MODEL:  The capital asset pricing model states that the theory of relationship between risk and return, which states that the expected risk premium on any security is equal to its beta, times the market risk premium. The expected rate of return demanded by investors depend upon two things; compensation of the time value of money (The risk free rate, T bill rate) and a risk premium, which depends on beta and the market risk premium. CAPM model predict a very realistic approach to calculate the expected rate of return for the investors who are holding stock for their required return. Many firms use this model because it is more accurate as compared to other models and also realistic in nature.

The formula for CAPM model is stated as,

R= Rf + B(Rm-Rf)

Where Rf is risk free rate (T bill rate) , B states beta on market return and Rm is return on market. This relationship in formula states that the investors should get a return on their stocks with calculation of risk free rate plus the risk they have incurred in holding the stocks. The rate should be above the risk free rate and also the return on market rate for the risk they have taken. The higher the risk the return on stocks would be higher. Even a little diversification can provide a substantial reduction in variability.

Suppose you calculate and compare the standard deviations of randomly chosen

one-stock portfolios, two-stock portfolios, five-stock portfolios, etc. A high proportion

of the investments would be in the stocks of small companies and individually

very risky. However, diversification can cut the variability of returns about in half. Notice also that you can get most of this benefit with relatively few stocks: The improvement is slight when the number of securities is increased beyond, say, 20 or 30. Diversification works because prices of different stocks do not move exactly together.

DIVIDEND GROWTH MODEL: Dividend growth model is that model, which states that today’s stock price equals the present value of all expected future dividends. A case in

point is the allocation of overhead costs. Overheads include such items as supervisory

salaries, rent, heat, and light. These overheads may not be related to any particular

project, but they have to be paid for somehow. Therefore, when the accountant assigns costs to the firm’s projects, a charge for overhead is usually made. Now our principle of incremental cash flows says that in investment appraisal we should include only the extra expenses that would result from the project. A project may generate extra overhead expenses; then again, it may not.

The formula from which we calculate the dividend growth rate is calculated as,

PV= (Div1/1+r)+(Div2/(1+r)^2)+(Div3/(1+r)^3)+ ……

The value of the stocks is the present value of the dividends it will pay over the investor’s horizon plus the present value of the expected stock price at the end of the horizon. This model assumes that the rate of growth would be consistent by the firms, which in real is not possible as they have already stated so. The rate of return on bonds can be consistent but the return on stock fluctuates as the company’s financial position varies. Many firms grow at rapid rate or irregular rates for many years before finally settling down.

IRR is calculated when company invest in other projects to see whether the project is profitable or not. The higher the IRR the greater the chances of success for a particular project and the greater will be the profit.

            Different companies use different methods to evaluate their investment decisions based on their past experiences and other data. Many firms when investing globally consider IRR factor as it is more important then ROE. ROE only focuses on the shareholders equity part where as the IRR factor consider several other factors which makes calculation more effective and decisions taken from IRR perspective are more valuable for the companies.

The other four members or the team are not able to give time for this venture but are ready for their investment in this project. For such cases they will be the investors of the company but they will not be allowed to interfere in managing the daily business operations. They will solely enjoy the profits in long-term basis. After certain time when steve and jan will pay more attention and will get involved in the business they will be actively participating in daily routine operations. They will be the partner pf the venture but they will be receiving the income for the time and services they will render for the company as in partnership agreements it is common.

ARBITRAGE PRICING MODEL THEORY: This theory states that when calculating different returns foe bonds and stock for investors it holds the expected returns on financial assets of the firm with estimating certain macro economic factors which can influence returns of bonds and stocks. The changes that are lead by changes in macro economic factors are stated by beta coefficient. There is a close link between Arbitrage theory and CAPM Model but it is less restrictive as compared to CAPM model but CAPM Model assumes realistic factors which make that theory more possible. The share and portion of business will be decided according to the investments and the skills and time required for making this venture workable. The partners will decide that which partner will owe what part of the business. The parts of business could be the Management activities, Dealing with the wholesalers and suppliers and the issue of financing for certain business activities.

Cash from operating activities is more important because company needs cash to run their business and to perform day to day operations so therefore they needs to make a strategy that how they can cover their cash shortfall because if there is no cash in the company that how would the daily tasks be done and if the production is not done then how they can cover their losses. To be in a profit the company needs to have Cash with their hands so that they can perform and can produce goods and generate revenues to be profitable in the business by covering Net Cash they will also cover the Loss the company had because in Cash Flow Statement the Net income is added in the Cash from Operating activities.

In my recommendation the CAPM mode is the perfect model for estimating the return for stocks and bonds for firms, as it is more realistic and also good for investors as well as for company. CAPM model can be effective if the company deals with the investors carefully. The company has to make it clear to the investors that they are getting the right rate of return as compared to other stock and market return.

SOURCES
John Downes, Jordan Elliot Goodman. 2006. Barron’s Finance ; Investment Handbook. Barron’s Educational Series.
Gene Siciliano. 2003. Finance for Non-Financial Managers: A Briefcase Book. McGraw-Hill Professional.
Richard A. Brealey, Stewart C. Myers. 1984. Principles of corporate finance. McGraw-Hill.
Peter J. Eisen. 2007. Accounting. Barron’s Educational Series.
Ray H. Garrison. 1985. Managerial Accounting: The Concepts for Planning, Control and Decision. Business Publications.