Why capital asset pricing model CAPM is more suitable to-02004
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vu mgt501 Human Resource Management.
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vu mgt501 Mid Term Solved Past Paper No. 1.
Capital Asset Pricing Model VS Dividend Growth Model
The dividend growth model approach has limited application in practice because of its two assumptions.
- It assumes that the dividend per share will grow at a constant rate, g, forever
- The expected dividend growth rate, g, should be less than the cost of equity, to arriveat 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 thosecompanies, which are not paying any dividends, or whose dividend per share is growingat a rate higher than cost of equity, or whose dividend policies are highly volatile. Thedividend growth model approach also fails to deal with risk directly. In contrast, theCapital asset pricing model has a wider application although it is based on restrictiveassumptions. The only condition for its use is that the companies share is quoted on thestock 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 allcompanies. The value of beta is determined in an objective manner by using soundstatistical method.
CAPM is generally seen as a much better method of calculating the cost of equity thanthe dividend growth model (DGM) in that it explicitly takes into account a company'slevel of systematic risk relative to the stock market as a whole.
