a. Describe the underlying assumptions and differences for the Capital Asset Pri

Question

a. Describe the underlying assumptions and differences for the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Provide an example in which type of situation each would be most appropriate to the task. Is there any situation in which using either method would be acceptable? Or neither, and if so, which pricing model would then be most appropriate? Explain.

b. You have been asked to perform a stock valuation prior to the annual shareholders meeting next week. The two models you’ve selected to value the firm are 1) the dividend discount model and 2) the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process. Also, explain why these prepared estimates may differ from the actual stick price today, or any given day.

c. In a "perfect world" capital market, how important is a firm’s decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued? Lastly, explain how you would respond to firm’s decision to cut its dividend.

Explanation / Answer

a. According to the CAPM, the Cost of equity Is denoted by Re and is given by the following equation

Re = Rf + beta*(Rm – Rf) where Rf is the risk free return, beta is the measure of systematic risk, Rm is the return of the market and Rf is the risk free return.

The Assumptions of CAPM are:

The Arbitrage Pricing Theory (APT) suggests the expected return of an asset could be modelling in linear fashion by taking into account the economic indicators and the market indices.

The assumptions of the APT are:

b. According to the Dividend discount model (DDM), the intrinsic price of the stock today is given by the formula :

P0 = D1/(Ke –g) where D1 is the dividend next year, Ke is the required rate of return and g is the growth rate of dividends

The discounted cash flow (DCF)model tries to discount the future estimated cash flows at the discount rate to get the correct price

The two models differ because the DDM evaluates the intrinsic value on future dividends where DCF evaluates the intrinsic value based on future cash flows

The prepared estimates are based on the events in the future like the dividend payout in future and cash flows in future. Since these events are forecasted and not accurate, the intrinsic price differs.

c. When the firm repurchases the shares, it means that the firm thinks that the shares are undervalued and hence they think the shareholders will directly give back the shares to the firm at a fixed rate. When the firm pays dividends, it means that the company is continuous generating profit and hence they are distributing it to shareholders.

The dividends generally have a dividend distribution tax(DDT) which reduces the overall return to the shareholders and the same in not present when there is share repurchase.

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