# The Capital Asset Pricing Model

## Dividend discount model

Dividend discount model = dividend per share/ discount rate – growth rate (Penman, 1997). For example, Microsoft’s preferred stock has an annual dividend of \$8. The expected rate of return is 10%. Thus, the values of preferred stock = (5/10×100) = \$50. The common stock was overvalued because the current value did not justify the earnings ratio.

## Stock’s beta

Stock beta can be calculated using the expected rate of return. The stock and market rate of return is provided during the calculation.

Stock’s beta = (Stock’s rate of return – expected rate of return) /market rate of return – the expected rate of return. When beta is less than one, the market value is unpredictable. When a stock’s beta is greater than one, the stock’s value is unpredictable. When the stock’s value is less than zero, it means the stock and market values are unpredictable. A stock’s beta is not a good measure of risk because it ignores market fundamentals and the price level (Womack & Zhang, 2003). A stock’s beta value cannot influence its future performance. For example, if the expected rate of return for stock X and Y are equal, the company’s performance must be the same. However, statistics revealed that beta predictions might not determine future performance. Thus, a stock’s beta is not a good measure of investment risk.

## Competing models

The competing models used to determine a company’s stock bargain include the weighted average cost of capital, the Fama & French three-factor model, and the capital asset pricing model. Fama & French’s three-factor model uses three variables to determine a company’s stock. The capital asset pricing model uses one variable. The weighted average cost of capital uses physical factors to calculate a stock’s market value.

## Debt financing

When a company obtains equity financing, it may signal negative outcomes for shareholders. For example, when stock analysts underestimate equity, new investors will reap higher net returns. However, debt financing may signal positive future performance because the company will be willing and able to repay its debt (Frank & Goyal, 2007). The pecking order theory stipulates the order of financial decisions. The company’s choice of financing is based on asymmetric information. Finance managers prefer internal funding and debt financing. New equity financing may be used as a last resort.

## Pecking order theory

The pecking order theory ignores economic developments such as tax, security cost, financial distress, market fundamentals, and growth (Fama & French, 1997). A company’s stock that has a fixed dividend value and equity is called preferred stock. A company’s preferred stock has more value than its common stock. The main variable of preferred stock is debt financing. Managers must pay dividends on preferred stock before paying dividends on common stock.

## Preferred stock

The cost of preferred stock can be computed using the current market value and dividend of preferred stock. Thus, the cost of preferred stock = dividend of preferred stock/ market value of the preferred stock. We can also use the expected rate of return to determine the cost of preferred stock. Thus, the cost of preferred stock = divided by preferred stock/expected rate of return. Three companies with preferred stock include Coca-Cola, Ford Motor, and Lockheed Martin Corporation. Ford Motor Corporation is an auto industry. It is the largest auto manufacturing industry in the US. Coca-Cola is the largest beverage industry in the US. Coca-Cola has regional and international subsidiaries. Lockheed Martin Corporation manufactures defense capabilities and space systems.

## Acquisition

Three reasons for acquisition include synergy, diversification, and growth. Synergy involves the combination of one or more products and services for future performance (Martynova & Renneboog, 2006). The strength of the acquired firm complements its weakness. Diversification involves the creation and distribution of products and services. The sole right of production may influence a company into diversification (Bruner, 2004). Acquisition influences a firm’s capital structure, thus, improving future performance. The company’s growth rate can be influenced by horizontal or vertical integration. The control of supply, product, and service is called horizontal integration. The increase in client population is called vertical integration.

## Hostile takeovers

A hostile takeover occurs when the acquiring firm announces a forceful bid on a target company. Usually, directors of the targeted company create resistance. Hostile takeovers between 2000 and 2008 include Mittal & Arcelor, Scchaeffler & AG Continental, and Lundin Mining & Equniox. In 2006, Mittal Corporation announced a hostile bid for Arcelor Corporation (Yang & Zarin, 2011). The hostile bid was subjected to three conditions, which include majority approval, minimum acceptance, and management. In 2008, Schaeffler Corporation announced a hostile bid for Continental AG. Schaeffler wanted to consolidate its shareholding status. In 2008, Lundin Corporation announced a hostile bid for Equinox. Equinox and Lundin Mining Corporation manufactures base metals in Canada and Australia. When hostile takeovers are signed, succession challenges hinder the performance of the new corporation.

## Strategies against hostile takeovers

Three strategies that companies use to deter a hostile takeover include staggered board, poison pills, and litigation. The targeted company creates a staggered board to cause friction and hold voting status. Poison pills are triggered on preferred stock when a hostile bid is announced. Using legal injunction to stall hostile takeovers is called litigation.

## References

Bruner, F. (2004). Applied mergers and acquisitions. Web.

Fama, F. & French, R. (1997). Taxes, financing decisions, and firm value. Web.

Frank, Z. & Goyal, K. (2007). Trade-off and pecking order theories of debt. Web.

Martynova, M. & Renneboog, L. (2006). Mergers and acquisitions in Europe. Web.

Penman, H. (1997). A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model. Web.

Womack, L. & Zhang, Y. (2003). Understanding risk and return, the capm, and the Fama & French three-factor model. Web.

Yang, E. & Zarin, S. (2011). Mergers & acquisitions: Hostile takeovers and defense strategies against them. Web.

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