Capital Asset Pricing Model : The CAPM or the Capital Asset Pricing Model is a model that helps in determining a theoretically correct required rate of return of an asset that helps in making decisions related to the addition of assets to a well-diversified portfolio. The model considers the sensitivity of assets to non-diversifiable risk. It is represented by beta (ß) or the expected return of the market and the expected return of a theoretical risk-free asset. Constant Dividend Growth Model: The constant dividend growth model considers the value of a company’s equity and its market cost of equity , by modeling the expected future dividends receivable by the shareholders as continuously growing perpetuity. It is used in the estimation of the market cost of equity from the current share price and the fair value of equity from a cost of equity, which can be either given or assumed. To determine: The major tradeoffs in using the CAPM versus the CDGM to estimate the cost of equity.

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Chapter 13, Problem 4CC

Summary Introduction

Capital Asset Pricing Model:

The CAPM or the Capital Asset Pricing Model is a model that helps in determining a theoretically correct required rate of return of an asset that helps in making decisions related to the addition of assets to a well-diversified portfolio.

The model considers the sensitivity of assets to non-diversifiable risk. It is represented by beta (ß) or the expected return of the market and the expected return of a theoretical risk-free asset.

Constant Dividend Growth Model:

The constant dividend growth model considers the value of a company’s equity and its market cost of equity, by modeling the expected future dividends receivable by the shareholders as continuously growing perpetuity. It is used in the estimation of the market cost of equity from the current share price and the fair value of equity from a cost of equity, which can be either given or assumed.

To determine:

The major tradeoffs in using the CAPM versus the CDGM to estimate the cost of equity.

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Scenario one: Under what circumstances would it be appropriate for a firm to use different cost of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier division or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division’s cost of capital?

Scenario three: If a portfolio has a positive investment in every asset, can the expected return on a portfolio be greater than that of every asset in the portfolio? Can it be less than that of every asset in the portfolio? If you answer yes to one of both of these questions, explain and give an example for your answer(s). Please Provide a Reference

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