This question called for a discussion of whether the dividend growth model (DGM) or the capital asset pricing model (CAPM) should be used to calculate the cost of equity. Many answers struggled to gain full marks.

It may be helpful to remember that the DGM calculates what the cost of equity appears to be in the capital market, while the CAPM calculates what the cost of equity ought to be, given a company’s level of systematic risk. The CAPM has a sound theoretical basis and hence is often recommended for calculating the cost of equity, especially as the DGM relies heavily on an accurate forecast of the future dividend growth rate, which is difficult to achieve.

In practice, the return predicted by the CAPM can be very different from the return that shareholders actually receive via dividends and capital gains (total shareholder return). Clearly, both models have strengths and weaknesses.

Some candidates also discussed that, in the context of the question, the CAPM could be used to calculate a project-specific cost of equity, while the DGM could not be used for this purpose. Credit was given for this line of discussion.