In your analysis of the cost o

In your analysis of the cost of capital for an ordinary share,you calculate a cost capital using a dividend discount model thatis much lower than the calculation for the cost of capital usingthe CAPM model.

1. Explain <using max 50 words> possiblesources for the discrepancy.



The dividend capitalization model can be used to calculate thecost of equity, but it requires that a company pays dividends. Thecalculation is based on future dividends. The theory behind theequation is the company’s obligation to pay dividends is the costof paying shareholders and therefore the cost of equity. This is alimited model in its interpretation of costs.

The capital asset pricing model, however, can be used on anystock, even if the company does not pay dividends. That said, thetheory behind CAPM is more complicated. The theory suggests thecost of equity is based on the stock’s volatility and level of riskcompared to the general market.The risk-free rate is the rate of return paid on risk-freeinvestments such as Treasuries. Beta is a measure of riskcalculated as a regression on the company’s stock price. The higherthe volatility, the higher the beta and relative risk compared tothe general market.

Hence, the higher cost of equity on such shares is due to thebeta factor involved which makes it more volatile to market riskpremium considerations.

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