Submitted by: Submitted by llgarn
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Date Submitted: 03/19/2016 01:47 PM
TUI UNIVERSITY
Leon Garner
FIN501
Strategic Corporate Finance, Module 2, Case
Dr. Joshua Shackman
August 26, 2010
Considering the three dominant asset pricing models, Dividend Growth Model (DGM), CAPM and APT, I believe that the best model for use in determining the cost of equity or required rate of return is CAPM. All three pricing models have advantages and disadvantages in use, however, the major advantage of simplicity of use that is embodied in CAPM, combined with the fact that it has been empirically tested for predictive accuracy and that it continues to be one of the most widely used asset pricing and investment models (Valued Based Management Net, n.d.) makes it my choice for utilization by Solutia Inc.
CAPM is a better fit for achieving the desired board aim of properly estimating the required discount rate as compared to DGM since this is the primary tenet of the CAPM formula (Required Return=Risk Free Rate x Beta (Expected Market Return Rate - Risk Free Rate)). In fact, the DGM utilizes the CAPM formula to arrive at cost of equity used in its model – DGM has two basic inputs – expected dividends and the cost of equity (Dividend Discount Model, n.d.):
The required rate of return on a stock is determined by its riskiness, measured differently in different models – the market beta in the CAPM, and the factor betas in the arbitrage and multi-factor models.
Whereas DGM is a pricing model that utilizes expected dividends, and their present values, to cost assets (e.g. equity stock) and measure the reasonableness / rightness of current market pricing of assets in efforts to aid purchase / sell portfolio decisions, however relative to the cost of equity or expected rate of return it does not improve upon the base CAPM formula. In addition, DGM is not recommended (i.e. is of no value) for asset pricing of stocks that do not pay dividends (QFINANCE,...