Cost of equity capital and the CAPM for Time Warner
Review the capital asset pricing model and the dividend growth model. Both models provide some insights and tools to estimate the rate of return that investors in Time Warner 'require' in the sense that if they don't see the possibility that they'll earn that rate of return they'll sell the shares and that of course will lower the market price per share.
Both models use a set of assumptions that are not necessarily tenable.
You are asked by the board of directors of Time Warner to write a report explaining the challenge of estimating or coming with a good 'feel' for the "cost of equity capital" or the rate of return that you feel your company investors require as the minimum rate of return that expect of require your company to earn on their investment in the shares of the company. Note that the investment is not the amount shareholders spent buying the share of the company in the past. The true investment is in terms of today's share prices because shareholders COULD have sold their shares today, and if they decided to hang on to these shares instead of selling these shares off this is their true investment in the shares of the company as of today. (This is the correct concept of the opportunity cost to the investors or the shareholders.)
Write a report to the board of directors of TIME WARNER regarding the following issues:
(1) In estimating the rate of return required by the shareholders on their investments in the company's equity one approach is to use the dividend growth model. Explain the assumptions that are necessary for using the dividend growth model, tell the board members how you would estimate the cost of equity or the required rate of return by the shareholders of the company using that model. Then briefly state and defend your position as to whether the model is appropriate for your SLP Company's use.
(2) An alternative, more sophisticated approach is to use the CAPM. Explain and state the assumptions used in the CAPM and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM.
(3) Finally give the board members some explanations as to how the CAPM is related to the so-called 'modern portfolio theory'. (Some members of the board heard of the model and are interested in your explanation to this issue)