Capital Asset Pricing Model/Cost of Equity/risk & Return

Answer question 1

What is the difference between the

A) Capital Asset Pricing Model

B) Material on the Dividend Growth Model

C) The Arbitrage Pricing Theory

Answer Question 2

Which of the 3 models above is the best one for estimating the required rate of return (or discount rate) for Raytheon Corp.

A) Ease of use of these three models

B) Accuracy of each of these 3 Models

C) How realistic are the assumptions of each model

Information for Question 3

The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using CAPM model is often more difficult than using the dividend discount model. The companies’ financial statements do not show the cost of equity.

The following table shows necessary (hypothetical) information to calculate the cost of equity by using CAPM model:

Company

Listing

RRF

RM

ßj

Nike Inc.

NYSE: NKE

0.40%

6.50%

0.90

Sony Corporation

NYSE: SNE

0.40%

9.50%

1.60

McDonald’s Corporation

NYSE: MCD

0.40%

8.50%

0.40

E(rj)= RRF + b(RM – RRF)

E(rj)- The cost of equity

RRF – Risk free rate of return

ßj – Beta of the security

RM – Return on market portfolio

Question 3

Based on the above information, which company has higher cost of equity? Why? Please explain your reasoning in brief. (Show work)

CAPM model shows that risk free rate of return, return on market portfolio, and company beta determine the cost of equity.