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Corporate Finance: Risk and return, portfolio diversification and CAPM - Federal Express

View Solution # 27305

Price: $10.00

The cost of equity capital and the CAPM
Review the background material on the capital asset pricing model, the material on the dividend growth model, and arbitrage pricing theory and do some of your own research using internet search engines and the CyberLibrary as well. These models provide some insights and tools to estimate the rate of return that investors in our company 'require' in the sense that if they don't see the possibility that they'll earn that rate of return they'll sell the shares and that of course will lower the market price per share.
These models use a set of assumptions that are not necessarily tenable.
You are asked by your board of directors to write a report explaining the challenge of estimating or coming with a good 'feel' for the "cost of equity capital" or the rate of return that you feel your company investors require as the minimum rate of return that that expect of require your company to earn on their investment in the shares of the company. Note that the investment is not the amount shareholders spent buying the share of the company in the past. The true investment is in terms of today's share prices because shareholders COULD have sold their shares today, and if they decided to hang on to these shares instead of selling these shares off this is their true investment in the shares of the company as of today. (This is the correct concept of the opportunity cost to the investors or the shareholders.)
Write a report to the board of directors (of your SLP Company Federal Express) in a five page paper addressing the following issue:
Which of the three models (dividend growth, CAPM, or APT) is the best one for estimating the required rate of return (or discount rate) of your company?
In your paper include discussion of the following issues:
1. Ease of use of these three models
2. Accuracy of each of these three models
3. How realistic the assumptions of each model are
For this paper you need to take a clear stand and pick one of these three models to defend to the Board of Directors. You cannot tell the Board of Directors that "I like all three models", they want you to come to them with a decisive choice of just one model.

Solution

The company chosen for the SLP is Federal Express. The solution provides a detailed discussion on investments and returns. Here the models chosen for the study include, Dividend Growth Model, CAPM Model, and Arbitrage Pricing Theory Model. Each of these have been explained in detail along with formulae. A conclusion is provided explaining the most effect model for the company. Appropriate calculations have been provided.

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Corporate Finance: Risk and return, portfolio diversification and CAPM - Federal Express

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