28 Oct s classmate’s discussion
Please respond to the following:
Why might the constant dividend growth model (CDGM) and capital asset pricing model (CAPM) produce different estimates of the cost of equity capital used in the weighted average cost of capital (WACC)? Describe the difference between permanent and temporary working capital. What are some factors an organization considers when it chooses the mix of long- and short-term capital to finance the organization’s activities?
*** 150-250 WORDS ***
If using reference/citations, Wikipedia is not a valid source.
Part 2 (TWO):
Respond to this classmate’s discussion using 50+ words.
“Because the purpose of issuing an equity security is to raise capital while providing shareholders expected returns, the “cost” of equity is “essentially the amount that a company must spend in order to maintain a share price that will keep its investors satisfied and invested (Seth, 2019). To determine this cost, two models are generally employed: the constant dividend growth model (CDGM) and the capital asset pricing model (CAPM). The primary area where these two models differ is that the former assumes there is a set dividend in perpetuity and all other external factors remain constant. Dividends are paid based on the financial health of the issuer and declared by a corporate board of directors as both a distribution of profits to the corporation’s owners and an incentive for investors to keep investing in the company (My Accounting Course, 2019). This model therefore isn’t a reliable tool for determining weighted average cost of capital (WACC) because it assumes that operating expenses, market risk, and dividend payouts remain constant and changes due to the economic or business cycles are irrelevant (Hayes, 2019). This model is also rendered worthless if the stock doesn’t pay dividends or required rate of return is less than the growth rate of dividends per share.
On the other hand, the CAPM utilizes the asset’s beta and compares it to the performance of the market and the risk-free rate of return to give a clearer picture of the cost of equity, especially when considering systematic risk (Berk, DeMarzo, & Harford, 2018). The CAPM also uses the benchmarks of a risk-free rate (e.g. Treasury securities) and Market Risk premiums (comparable index) to give investors a more realized required rate of return and therefore a superior model to use when calculating WACC.
- Describe the difference between permanent and temporary working capital.
Permanent working capital is the amount that a firm must keep invested in its short-term assets to support its continuing operations and promote future investment by matching this allocation with long-term sources of funds (Berk, DeMarzo, & Harford, 2018). Prime examples of permanent working capital include raw materials, operating equipment, or cash reserves. Alternatively, temporary working capital is the difference between short-term working capital needs and its permanent investment counterpart. Temporary working capital is indicative of a short-term need and is often financed since tying up funds in long-term investments isn’t feasible or ideal when the need is generally due to seasonal or cyclical fluctuations in the business.
- What are some factors an organization considers when it chooses the mix of long- and short-term capital to finance the organization’s activities?
When choosing to finance working capital to meet operational needs, a firm can take either an aggressive or conservative approach with the former using more short-term debt and the latter with an emphasis on long-term debt. Factors to consider when choosing a financing option include the repayment terms of the debt with shorter terms requiring more substantial periodic payments and longer involving more interest payments until satisfaction. The impact that financing has on a firm’s creditworthiness should also be noted, as an aggressive policy is less-sensitive to this attribute but the trade-off being exposure to funding risk (Berk, DeMarzo, & Harford, 2018). Alternatively when choosing the conservative policy may leave more cash on hand but because so much funding is tied up in the market there is the propensity of a firm’s value to be affected by downturns in the market. Each firm’s approach is therefore specific to their individual needs so it may take some continuous tweaking until an ideal balance can be achieved.”
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