Report To The Board Of Directors

After all the assessment and examination of the issues and reviewing all the key factors I put forward this report in order to resolve the issues.

ISSUES

(1)       Under the dividend growth model the current price of common stock is determined by the present value of all future dividends. If the stock is sold at some point in the future, its value at that time will be the present value of all future dividends.

Assumptions for Dividend Growth Model:

• Dividends grow at a constant rate
• The growth rate is less than the required rate of return; otherwise model breaks down since the denominator would be negative. Under such a happy condition, the investor’s return expectation should be reexamined and raised.
• Stock pays dividend
• The constant growth rate will continue forever

Estimation of Cost of Equity or Required Rate of Return

In order to make an example it is important to simplify the above query.

Current forecasts are for XYZ Company to pay dividends $3, $3.24 and $3.50 over next three years,respectively.At the end of three years you anticipate selling your stock at a market price of $94.48.What is the price of stock given a 12% Expected Return?

(Brigham & Houston, 2004)

Explanation of Using This Model and Suitability for Company’s Use:

The specific fluctuations and general trends in the securities markets are not taken into account by the dividend growth model. Obviously, the market value of specific shares can’t be independent of movements in the securities markets as a whole, which are caused by

• Macroeconomic factors like inflation, industry conditions, taxation, political events, and myriad other factors.
• With respect to micro factors we should consider the payout ratio, dividend payout history, investment plan, industry trends, organization life cycle etc.

In my assessment this model is quite feasible for companies in order to find out the correct valuation of stock in a manner that how much stock can generate dividend at the horizon date. In this particular model we also find out the horizon value (the future cash flow stream). Moreover, the value of a company’s shares reflects the collective performance assessments by security analysts, institutional and individual investors, and the resulting demand for, or lack of interest in, those shares.

(2)       CAPM is based on the proposition that any stock’s required rate of return is equal to the risk free rate of return plus a risk premium that reflects only the risk remaining after the diversification or we defined in a manner that the relevant riskiness of an individual stock is its contribution to the riskiness of a well diversified portfolio. (Brigham & Houston, 2004)

The formula of CAPM is

(Erich A. Helfert, 2001)

Assumptions of CAPM

• All investors have the same belief with respect to distribution of returns or we can say that all investors have homogenous expectations of returns within a specified time period and which are based on all the available information at the time.
• All investors have same time period like One year or Two year.
• No taxes and transactions/Brokerage costs are imposed when buying or selling securities (investments are subject to paying capital gain or loss taxes).
• Investors are indifferent between capital gains and dividends
• When we make our investments make sure that market are in equilibrium or stable in position and reflect the correct proposition of the market and all investments are properly priced in line with their risk levels and the market is efficient means working on Efficient Market Hypothesis (EMH).
• No room for inflation under this model.
• All investors can borrow or lend at the risk-free rate

Estimation of required rate of Return under CAPM Approach

For example we can assume that the risk free rate is 6% and the expected return on the market is 13%.Beta is 0.7 we required to estimate the required rate of return?

                                                          = 6% + 0.7(13% – 6%)

                                                         = 10.9%.

(Brigham & Houston, 2004)

3)         As we know that all investors are focusing on the risk of individual securities in order to maintain feasible portfolio of their investment. All investors working on the above quote high risk high return low risk low return. Keeping all the things in consideration different models and theories emerge as one in CAPM and in Modern portfolio Theory. There is a relation between these two.

• CAPM concludes that all investors should hold the market portfolio and the Portfolio theory provides a broad context for understanding the interactions of systematic risk and reward.
• CAPM introduces the beta β and the theory holds on a broad context for understanding the interactions of systematic risk and reward.
• There are no transaction costs in buying and selling securities both in CAPM and in Modern portfolio Theory.
• The investor does not consider taxes when making investment decisions and also Investors are rational and risk adverse both of the assumptions is lying on CAPM as well as in the Theory.
• Investors have same or identical information regarding the market risk and how the market will respond.
• In both CAPM and in Modern portfolio Theory works on risk.CAPM works on SML or BETA β and theory states on Efficient Frontier.

REFERENCES:

• Helfert, Erich A. (2001). Financial Analysis Tools And Techniques: A Guide For Managers. McGraw-Hill.
• Brealey, Richard A., Stewart C. Myers, Alan J. Marcus (2001). Corporate Finance. McGraw-Hill.
• Brigham, E., Joel Houston, Eugene Brigham (2001). Fundamentals Of Financial Management. Harcourt College Publishers.