CAPM formula shows the linear relationship between the return required on an

# Capm formula shows the linear relationship between

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CAPM formula shows the linear relationship between the return required on an investment and its expected risk. R E = r f + E ( r m )− r f ¿ β R E = 3.88%+ 0.86(18.13% - 3.88%) = 16.135% Where, r f refers to the risk free rate and its value is denote as the Malaysia Government 10Year Bond. ( ) β refers to the Beta of SOP shares and its value is denote from Reuters.com. ( ) Page | 11
FNCE3000 Corporate Finance Semester 1, 2015 E ( r m ) refers to the market rate of return and its value is denote as index point and later change to %. ( ) E ( r m )− r f ¿ refers to the market risk premium and its value is denote by subtracting market return and risk free rate. 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% Security Market Line Require rate of return Linear (Require rate of return) BETA of SOP Shares RETURN The above graph shows the Security market line (SML) of SOP stocks, the line shows the return on a given investment in relation to SOP shares risk. The risk is measured using beta. The line begins with the risk-free rate with zero risk/ beta at 3.88% and moves upward to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. The expected return on equity of SOP with a beta of 0.86 falls at 16.14% as shown on the SML graph. In general, investor with a low risk profile or risk adverse would choose an investment at the beginning of the security market line. While investor with a higher risk profile or risk taker would select their investment to be higher along the security market line. Page | 12
FNCE3000 Corporate Finance Semester 1, 2015 The other method of calculating cost of equity is through Dividend Growth Model (DGM). DGM is a valuation method which takes into consideration dividend per share and its expected growth. DGM can also be known as the Dividend Discount Model or the Gordon Growth model. It is the key valuation technique for dividend stocks. There are two types of DGM methods of calculating the cost of equity and one of them is the Constant Dividend Growth Model, and also the Multistage Growth Model. The general DGM formula is expressed as: P 0 = D 1 / K e g R E = D 1 P 0 + g To calculate Growth rate (g): g = D 1 D 0 1 = D 13 D 12 1 = 0.06 0.05 1 =0.2 or 20% To calculate D 1 : D 1 = D 0 ( 1 + g ) D 14 = D 13 ( 1 + g ) = 0.06 (1+0.2) Page | 13
FNCE3000 Corporate Finance Semester 1, 2015 = 0.072 Hence, R E = D 1 P 0 + g ¿ D 14 P 13 + g ¿ 0.072 5.09 + 0.2 = 0.214 or 21.4% Where, D is the dividend on the particular year, for example D 13 represent dividend in year 2013. The value is taken from annual report. R E refer to the required rate of return on equity. P is the price of shares in the particular year, for example P 13 represent price of share in year 2013. ( ). As demonstrated by both methods, the results are 5 % gap difference with CAPM generates 16.135% while DGM generates 21.4%. This may shows DGM more appealing because of its much higher required rate of return than CAPM. However, judging from the annual report dividend on 2014 is rather less than or doesn’t change from the dividend in 2013 that is 0.06.
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