Cost of equity capital Essay
Cost of equity capital
The rate of return that is required is employed in evaluating equity and is the least percentage in a year that is gained by investments of a company through the investors. The cost of equity is the rate of return on investments that is required by the shareholders of a company. The paper will discuss the three models which are the dividend growth, the CAPM and the arbitrage pricing theory. This will be in order to determine which one of them is the best for anticipating the rate of return required. It will also discuss the factors that influence the beta of a company in order to determine the cost of equity.
The best model for estimating the required rate of return
Dividend growth model is the best for estimating the required rate of return of the company because it is simple in terms of calculations. It is not complicated to apply and enables investors to calculate the growth of their stock easily. This model does not require a specialist and accurate decisions are made on time. This model enables the firms that use it to grow in a rate that is stable and their profits grow at the same level with the dividends. This ensures the investors that the company will meet up their compulsions. It is the best because it is constant as shareholders do not receive more dividends when the company increases profits more than expected. It is a way of determining the value of a share with regard to the current value of the dividends that the company expects to achieve in the future. Dividends can be described as the cash flows that are given back to the shareholders.
Recommendation to the board of directors
I would recommend to the board of directors that the SLP Company should use the dividend growth model because it is not complicated. It is also certain as the investors are given a fixed rate of return enabling the company to grow steadily. The model also has a basis that is logical as the investors are paid dividends according to their shares. It is also predictable and constant and that is why I would recommend it to the board of directors.
Ease of use
The simplicity of using the Capital Asset Pricing Model is because it has got relatively simple formulae to use. r = rF + β*(rM – rF)
r = requisite rate of return of financial assets
β = financial quality beta
rF = risk free pace
rM = required charge of return of market portfolio
The model also determines the type of index which suites the company market. For instance, if the business owner feels that the Russell 3000 best represents the business, it is necessary to use it since it is available. The model also looks for beta asset values as computed by Google, finance and yahoo finances. The simplicity of the Arbitrage Pricing Theory is the fact that the model is not restrictive in comparison to other pricing models and theories. The ease use of the divided growth is the fact that it is both easy to use and understand.
The accuracy of the Capital Asset Pricing Model is that it provides accurate and reasonable results. By use of its formulae correctly and enough data, accuracy is achieved easily. The fact that the Arbitrage Pricing Theory includes more factors, the theory is also considered more accurate in comparison with the Capital Asset Pricing Model. Since the dividends are fixed during payment, the divided growth is also an accurate method. The method also requires reasonable accurate in order to be effective and accurate.
Capital asset pricing model is based on some fundamental assumptions. For instance, it is true that the investors have similar homogeneous beliefs based on returns for they are interested in maximizing returns commencing their investors. Additionally, the assumption that most people access information on the investment opportunities is evenly practical in a market which is perfect. On the asset pricing model, the assumption that systematic risks exist is true for the environment operated in is full of risks from the external and internal sources. The risks do not have an influence on the investment’s rate of returns. Under the dividend growth model, the fact that it is a powerful and simple tool to use its application is also limited to the businesses developing at a rate which is stable. The model also tends to ignore the organizational cycles where the businesses begin and later declines.
The cost of equity is an evaluation that is used in analysis which shows the rate of return that an investor requires. This involves the dividends to evaluate them and be able to take the possibility of investing in a firm.
The cost of equity (E(rj) is equal to (RRF) plus beta of the security ßj multiplied by return on market portfolio RM minus (E(rj)= RRF + βj (RM – RRF)
For Nike Company the cost of equity is 0.40% + 0.9(6.50% – 0.40%) =5.89
For Sony corporation the cost of equity is 0.40% + 1.60(9.50 – 0.40) = 14.96
For McDonald’s Corporation the cost of equity is 0.40% + 0.40(8.50% -0.40) = 3.64
The company with higher cost of equity is McDonald’s Corporation because it has the lowest figure compared to other companies. This is because the return is too low which indicates that the cost of equity is high. The theory of finance suggests that when the possibility of investing in a company is high the cost of equity also goes high and when the possibility decreases the cost also goes down.
Some of the factors that influence a company beta include; the company’s tax exposure, business risk, the kind of management style, financial flexibility, the market conditions and the growth rates. These factors influence the company beta in different ways.
The company’s tax exposure affects the company beta in that the debt payment’s tax is deductable. Therefore, if the origination’s tax rate is at a high position, by use of debt as a channel of financing a project for example is attractive for the deductable tax debts protects profits for the taxes. On the business risk, if the organization risk is high, the optimal arrears ratio is lower.
The kind of management style lies between aggressive to constructive activities. If the management approach is aggressive, there is room for the company to become firm by the use of vital debts amounts to increase a company’s share hence development. On the other hand, if the management is constructive, it is less disposed to use the debts as a way of increasing profits. Some of the companies that acquire their finances from borrowing and debts among other methods tend to find conflicts associated with these because the growth firm revenues are not proven and are typically unstable.
The market conditions are also influential on the company’s beta. For instance, if a firm has got the need to borrow money for a certain project, the fact remains that the bazaar is struggling and the investors tend to limit the access of companies to capital because of issues with, market concerns. This is likely to affect the company negatively. The financial flexibility allows organizations to raise money even in hard times. The higher financially stable a company is, the less the debts and hence fast development.
The paper has discussed the ease of the three models which include the dividend growth, CAPM and the arbitrage return theory. It has also discussed into details the accuracy and the reality of each model in order to determine which one is the best for the company. It has shown that the dividend growth model is the best because it is easy for the company and investors to apply and calculate, it is certain and predictable, has logical basis and is constant because an increase in the earnings does not lead to increase in dividends to the investors which is very beneficial to the company. It has also discussed into details the type of factors that influence the beta of the company. The paper has also done calculations to determine the company with the highest cost of equity. It has also discussed the factors that lead to higher beta of the company.