ACCA AFM Syllabus B3cd. The Cost of Capital - DVM or CAPM? - Notes ^{4 / 5}

The dividend growth model allows the cost of equity to be calculated using empirical values readily available for listed companies.

Measure the dividends, estimate their growth (usually based on historical growth), and measure the market value of the share (though some care is needed as share values are often very volatile).

Put these amounts into the formula and you have an estimate of the cost of equity.

DVM

The current share price and dividend is easily known but..

• it is very difficult to find an accurate value for the future dividend growth rate

• using a historic growth rate as a predictor of the future isn't based on fact

The equation:

• (Dividend next year / Share Price) + Growth
       
  might suggest that the rate of return would be lowered if the company reduced its dividends or the growth rate.

  That is not so. All that would happen is that a cut in dividends or dividend growth rate would cause the market value of the company to fall to a level where investors obtain the return they require.

CAPM

has a sound theoretical basis, relating the required return of well-diversified shareholders to the systematic risk they face through owning the shares of a company. However...

• finding suitable values for the risk-free rate of return & equity beta can be difficult

DVM difficulties

• The dividend growth model has several difficulties. 

  For example, it impractically assumes that the future dividend growth rate is constant. 

  The dividend decision depends on past trends but also current conditions.

  The historic dividend growth rate is used as a substitute for the future dividend growth rate.

• The model also assumes that business risk, and the cost of equity, are constant in future periods, but reality shows us that companies are subject to constant change.

  The dividend growth model does not consider risk explicitly in the same way as the CAPM. 

  Here, all investors are assumed to hold diversified portfolios and as a result only seek return for the systematic risk of an investment.

• The individual components of the CAPM are found by empirical research and so the CAPM gives rise to a much smaller degree of uncertainty than that attached to the future dividend growth rate in the dividend growth model.

  For this reason, it is usually suggested that the CAPM offers a better estimate of the cost of equity than the dividend growth model.