Part 1: Please Respond To Why Might The Const

Part 1 Oneplease Respond To The Followingwhy Might The Constant Di

Part 1 Oneplease Respond To The Followingwhy Might The Constant Di

Analyze why the constant dividend growth model (CDGM) and the capital asset pricing model (CAPM) might produce different estimates of the cost of equity capital used in the weighted average cost of capital (WACC). Explain the difference between permanent and temporary working capital. Discuss some factors an organization considers when choosing the mix of long- and short-term capital for financing.

Paper For Above instruction

The estimation of the cost of equity capital is critical in financial decision-making, particularly in calculating the weighted average cost of capital (WACC). Two prevalent models used for estimating this cost are the constant dividend growth model (CDGM) and the capital asset pricing model (CAPM). While both aim to determine the expected return demanded by investors, they often produce different estimates owing to their underlying assumptions and methodologies.

The CDGM, also known as the Gordon Growth Model, assumes that dividends will grow at a constant rate indefinitely. It simplifies valuation by focusing solely on dividend expectations and their growth, making it particularly useful for stable, mature companies with consistent dividend policies. However, its reliance on the assumption that dividends grow at a steady rate can lead to inaccuracies if dividends are irregular or if the growth rate exceeds the risk-free rate, which can result in negative or nonsensical valuations. The model also assumes that the required rate of return exceeds the growth rate, a condition that might not hold in volatile or declining companies. Moreover, the CDGM does not account for market risk or systematic risk factors that influence a company's stock price, limiting its scope in accurately capturing the true cost of equity in dynamic markets.

In contrast, the CAPM estimates the cost of equity by considering the systematic risk associated with the stock relative to the market. It incorporates the risk-free rate, the stock’s beta (a measure of volatility relative to the market), and the market risk premium. This approach considers market risk factors and investor expectations more comprehensively than the CDGM. Because CAPM accounts for systematic risk, it tends to provide a more nuanced and adaptable estimate of the required return, especially in volatile markets where dividends may not grow at a predictable rate. However, CAPM's reliance on beta and market risk premiums can introduce estimation errors, and its assumptions about market efficiency and investor rationality may not always hold true, leading to potential discrepancies in the estimated cost of equity.

The choice between these models can lead to different estimates of the cost of equity, primarily because the CDGM is more sensitive to dividend stability and growth assumptions, while CAPM incorporates broader market risk factors. Consequently, in stable, dividend-paying companies, CDGM may be adequate; however, for firms with irregular dividends or higher market volatility, CAPM might provide a more reliable estimate.

Understanding the distinction between permanent and temporary working capital further clarifies a firm's operational and financing strategies. Permanent working capital refers to the minimum level of resources a company must consistently invest in short-term assets to support ongoing operations. It is essential and remains relatively stable over time, covering core operational expenses such as raw materials, inventory, and cash reserves necessary for daily functioning. This form of working capital is usually financed through long-term sources, ensuring stability and reducing refinancing risks.

Temporary working capital, on the other hand, arises from short-term fluctuations in business operations, such as seasonal inventory build-up or cyclical changes in demand. It is variable and financed separately from the permanent component, often through short-term borrowings or credit lines. Temporary working capital management involves addressing these cyclical needs efficiently without impeding long-term financial stability.

When organizations decide on their financing mix of long- and short-term capital, several factors influence their choices. Companies adopting an aggressive financing approach tend to rely more on short-term debt, which is cheaper but exposes them to refinancing and liquidity risks. Conversely, a conservative strategy emphasizes long-term debt or equity, reducing refinancing risk but potentially increasing overall capital costs.

Key considerations include the cost of debt, payment terms, interest rate stability, and the company's creditworthiness. Firms aiming to minimize interest expenses might prefer short-term financing, but this increases vulnerability to interest rate fluctuations and refinancing difficulties. Those prioritizing stability might lean toward long-term debt or equity to lock in fixed costs and ensure continuity. Additionally, the prevailing economic environment, market conditions, and the company's cash flow predictability influence the decision. Firms also assess their risk tolerance, operational needs, and strategic objectives to establish an optimal financing structure. Regular review and adjustment are necessary given changing market dynamics and organizational priorities.

References

  • Berk, J., DeMarzo, P., & Harford, J. (2018). Fundamentals of Corporate Finance (5th ed.). Pearson.
  • My Accounting Course. (2019). Dividend Discount Model (DDM). Retrieved from https://www.myaccountingcourse.com/
  • Seth, H. (2019). Cost of Equity Explained. Harvard Business Review.
  • Hayes, R. (2019). Understanding the Capital Asset Pricing Model. Journal of Financial Planning.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
  • Damodaran, A. (2019). Applied Corporate Finance (4th ed.). Wiley.
  • Ross, S., Westerfield, R., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance (14th ed.). Pearson.
  • Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives.
  • Fisher, J., & Statman, M. (2000). The Cost of Capital and Investment Decisions. Financial Analysts Journal.

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