Question

Explain the standard CAPM method to estimating cost of equity, and how we estimate the market risk premium and risk-free rate (and why we use this method) Where might we find a beta estimate? Explain the potential problems with this approach. Explain why we might need to rely on data from the company’s 10-k to determine the cost of debt, rather than using only the firm’s market-traded bonds. Why would we want to know more than the interest expense reported on the income statement? Calculate cost of equity, cost of debt, and WACC Explain the basics of the dividend discount model for valuation. Explain the problems with implementing this model

Answer 1

Teh basic CAPM equation is:
Cost of equity = Risk free rate +Beta*(Expected return on market-Risk free rate)
We use this method as its inputs are easily availaible and can be calculated easily

Beta needs to be calculated using the company's stock returns with respect to the market benchmark returns. It is the slope of the regression lines between these two returns.

Now the problem with the approach is that beta is the return on the equity stock with respect to the market. First of all the relationship over time may not be same due to a variety of factors.  It also assumes that investors could ewasily lend and borrow at risk free rate which is rarely possible. It also assumes perfect capital market. Also assumes invetors hold diversified portfolio which is not always possible.