Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a powerful analytical tool used for calculating the price of common stock. After reflecting on theory and application of the CAPM model and reviewing the prior work on the Constant Dividend Growth Model post a one paragraph response to the following questions.
Question 1 – What are the primary advantages and disadvantages of the Capital Asset Pricing Model (CAPM) compared with the Constant Dividend Growth Model for use in pricing common stock?
Question 2 – Can either or both of these two models be used to price the stock of Gamma Inc., a non-publicly traded company that does not pay dividends? Explain your answer.
Question 3 – Why is it that the financial models for calculating the price of a stock cannot be reliably used to make day to day investment decisions in the stock market?
Capital Asset Pricing Model
Unlike the constant dividend growth model (DGM) which assumes that the dividend growth rate is known and stable, capital asset pricing model (CAPM) takes into account the level of systematic risk vis-à-vis the stock market as a whole. Secondly, CAPM eliminates unsystematic risk unlike DGM which assumes that stock price is hypersensitive and that the dividend growth rate cannot be higher than the cost of equity (Thomas & Gup, 2010). DGM ignores market conditions, thus making it easier to compare different companies whereas CAPM uses backward looking market returns which may be inaccurate in predicting future market returns. Additionally, CAPM’s primary assumption of borrowing and lending at a risk-free rate makes the minimum required return inaccurate because
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