most suitable model for Dell Company in evaluating the required rate of return on investments
Every investor is encouraged to pursue an investment in a certain venture by the performance of that business enterprise as reflected in the prices of its shares in the market. Before an individual or a corporate decides to invest in a certain stock, the investor is always guided by the rate of return the investment will receive annually (Brigham & Houston, 2007). When an investor buys stock of a certain company, he will receive two kinds of cash flows notably dividends during the period of investment as well as expected price after the holding period (Thomsett, 2009). Companies have therefore embarked on strategies meant to induce the investors in buying their stock in the market. To achieve this, they need to stipulate the required rate of return on the stock an individual or a corporate is buying. The investors are always paid residual interests after all the company liabilities are settled (Thomsett, 2009). In order to estimate the required rate of return on the stock bought and held by investors, a variety of models are utilized. These models may include dividend growth model, capital asset pricing model (CAPM), as well as Arbitrage pricing theory (APT). This paper therefore discusses the aforementioned theories as well as identifying the most suitable model for Dell Company in evaluating the required rate of return on investments (Brigham & Houston, 2007).
Dividend growth model
Different companies employ different model in estimating the required rate of return shareholders expect to receive on their investments. These models are varied in applications. To begin with, the dividend growth model is a theory employed by the companies whose annual growth is constant and not expected to change in the future (Siegel, 2007). The model assumes that the dividends payable by an organization to the investors will be constant in growth rate annually (Ogilvie, 2008). According to Ogilvie (2008) segmentation of the organization’s lifespan during which variability apply is inevitable incases where the growth rate changes. This is then followed by the valuation of each period separately (Ogilvie, 20208). These assumptions seem quite unrealistic to achieve given the changes of business environments all over the world. For instance, any economic downturn such as that witnessed in 2008 may likely to affect a business negatively thereby altering its growth rate. It is therefore useful only to the organizations whose growth rates are stable and moderately low (Siegel, 2007). Since investors venture into shares whose dividends grow with expectations that they would sell the shares at higher prices, the model would not be useful to them in any way. However, this model has its strengths as well. Dividend growth model can be very important in the estimation of marginal shareholdings (Olgive, 2008).
Capital asset pricing model (CAPM)
Capital asset pricing model (CAPM) on the other hand is a very important asset pricing theory that gives the business community their perception about the relations between risks and the expected returns as well as the pricing of the market risks (Constantinides et al, 2003). According to the model asking investors to accept supplementary risks would elicit their demand for an increase in the expected returns. They reiterate that the investors will not pursue the investments in cases where expected returns do not exceed or meet the required returns. According to Constantinides et al (2003) the aforementioned model has the limitation of explaining how the risk and the expected returns are related. Moreover, the assumptions made by the model are unrealistic as well. For instance, the assumption on a single period time theory based on the fact that investors are only interested in the wealth their portfolio is generating at the end of the current period is not true (Constantinides et al, 2003). According to Kürschner (2008) investors are always securing their consumption in a lifetime by long-term investments unlike the notion held by the model. Moreover, the model is based on the forward-looking information such as expected returns which can not be valuated with accuracy and would therefore be determined by hysterical data. The exclusion of operation costs and taxes as well as lack of free and readily available information are some of the unrealistic assumptions of the model. Further it is not expected that all investors would be logical about their expected returns in addition to having uniform expectations (Kurschner, 2008). Finally, Kurschner (2008) notes that risk-free assets are non-existent in the business world contrary to the assumption of the CAPM model.
Arbitrage pricing theory (APT)
Unlike CAPM, Arbitrage pricing theory (APT) is an evaluation model that is harder to use even though it has fewer assumptions than the former model (Giovanis, 2010). According to the model, the security prices are determined by a variety of factors including company factors as well as macro factors. Giovanis (2010) reiterates that the theory does not depend on the market performance measurements and therefore links the security prices to the factors that directly affect the prices. However, the model does not specify the factors calling for empirical determination. Another profound difference between this theory and the Capital asset pricing model is that the former has a single beta as well as non-company factor whereas APT has numerous non-company factors each requiring a separate beta. The sensitivity of the security price of a factor is determined by its beta. The model provides no guarantee in determination of the factors in addition to complexities in calculations of beta especially when the factors are numerous. Generally, the use of this model is a bit complicated.
Of the three above discussed models, I would propose adoption of Arbitrage pricing theory (APT) in the evaluation of stock in the Dell Company. To begin with, the model has fewer assumptions compared to the other two models whose assumptions are quite unrealistic. Its flexibility in the assumptions makes the model be considered as an alternative to ACPM. The model provides a deep understanding of the relationship between the origin of risks in the financial realm and nature by providing a sound description of the risks and return (Giovanis, 2010). It also provides an understanding on how investors bearing risks are rewarded by the capital market. Even though the model does not indicate the factors, the macro-factors are plausible. Additionally, there is no need to correctly measure the market performance since the model directly links the security prices to the factors that affect the prices (Mei, 1994). The ATP model is used by the Arbitrageurs to profit by utilizing mispriced securities. In most cases, mispriced securities always costs differently from the model’s predicted price. Finally, the arbitrageur a profit that is theoretically risk-free by going long the portfolio which the calculations were derived while at the same time going short an over-priced security (Mei, 1994).
Investors always pursue an investment activity with a main aim of reaping returns. The companies in which such investments are undertaken are therefore bound to offer dividends on the shares held by an investor. This is highly dependent on the performance of the firm in regard to its share prices. Investors usually buy the shares with an aim of holding them and later selling the shares when their prices heighten in order to make profits. The firm has a mandate to device strategies of estimating the rate of returns ion such investments. Attractive rate of returns always encourage investors to buy shares of a certain company. The management teams of such investment companies have to adopt one of the existing models on the valuation of stock or estimation of rate on returns. These models include dividend growth model, capital asset pricing model (CAPM), as well as Arbitrage pricing theory (APT). The above mentioned models assume different applications and have varied weaknesses and strengths as well. For instance, dividend growth model is applicable to companies that demonstrate constant and moderately low growth rate. Dell Company is a multi-national company with a large capital base and in whose shares the investors have ventured. Just like other for profit organizations, Dell Company has to device strategy meant to induce investors in buying its shares. To achieve this I have proposed that the company consider utilizing the Arbitrage pricing theory in estimating rate of return. The models has commendable strengths including fewer assumptions, elaborate description on the relationship between risks and returns and does not depend on the measures of the performance of the market.
Brigham, E. & Houston, J. (2007). Fundamentals of financial management. 11TH Ed. Florence:
Cengage Learning, 2007
Constantinides et al (2003). Handbook of the economics of finance. Maryland: Elsevier.
Giovanis, E. (2010). Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing Theory
(APT) Models in Athens Exchange Stock Market. Munich: GRIN Verlag.
Kurschner, M. (2008). Limitations of the Capital Asset Pricing Model (CAPM): Criticism and
New Developments. Munich: GRIN Verlag,
Mei, J. (1994). New methods for the arbitrage pricing theory and the present value model.
Hackensack: World Scientific.
Ogilvie, J. (2008). CIMA Official Learning System Management Accounting Financial Strategy.
5th Ed. Maryland: Butterworth-Heinemann.
Siegel, J. (2007). Stocks for the long run: the definitive guide to financial market returns and
long-term investment strategies. 4th Ed. London: McGraw-Hill Professional
Thomsett, M. (2009). Getting Started in Options. 8th Ed. New York: John Wiley and Sons.