MoD 3 FIN501 Risk and Returns Protfoli Essay Example | Topics and Well Written Essays - 1250 words

MoD 3 FIN501 Risk and Returns Protfoli - Essay Example We can use the following models to determine a company's required rate of return: 1) Dividend Discount Model: The dividend discount model is an example of a present value model of stock valuation in which dividends are used as stream of cash flows and the present value of the stream of dividends is defined as the value of the stock. The basic assumption of this model is that an investor who buys a share receives return only in the form of dividends. This assumption strictly holds for dividend paying stocks and for companies that are stable and pay a constant amount of dividend to its share holders. Companies that are categorized as high growth companies do not pay out dividends to their share holders since the excess funds are invested elsewhere in the business to exploit the existing growth opportunities (Madura, 2008). Hence DDM is not a suitable model to use for high growth companies that do not pay out dividends to its shareholders. Another assumption of the model is that there a re no taxes and transaction costs. This is a false assumption since dividends earned are taxed in most of the countries. DDM is one of the oldest and easiest model to calculate a company's required rate of return. ... The required rate of return is very sensitive to the inputs used in the DDM constant growth formula and hence the value of required rate of return is as good as the assumptions used by an analyst. DDM also assumes that the prices are efficient and the intrinsic value of a stock is equal to the market price of a stock. This assumption does not hold in equity market indices of developing markets. In conclusion, DDM is appropriate for valuing a company's required rate of return when its key assumption of steady future dividends hold. Most of the Equity market indices of developed markets satisfy this assumption. Lastly, an analyst should be aware of the fact that the output of the model is very sensitive to the inputs used and the model's accuracy largely depends on the assumptions used by an analyst. 2) Capital Asset Pricing Model (CAPM): CAPM is an equation that can be used to calculate the required rate of return of a stock. CAPM is one of the widest used models in finance to calcula te the required rate of return because of its comparatively objective procedure of calculating a company's required rate of return (Jaffe, Westerfield, & Ross, 2005). Following equation can be used to calculate the required rate of return in CAPM: One of the assumptions of CAPM is that the shareholders are risk averse and they make the decision to invest in a stock based on the mean return and variance of returns of their total portfolio . This assumption does not hold in developing markets where investors are not very knowledgeable about the concepts of portfolio management. Another assumption of CAPM is that there are many investors in the market and all of those investors are price takers. This assumption does not hold true if the financial markets are not