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Capital Asset Pricing Model

When evaluating a firm for investment purposes, Capital Structure Analysis is one of the most crucial things to consider (Kumar, Colombage & Rao 2017). The sources of money available to a firm for funding its activities are evaluated as part of the capital structure study. It entails determining a perfect balance between debt and equity capital sources in order to keep the cost of capital as low as possible. The goal of this research is to calculate the cost of equity of Sage Group, a multinational software firm situated in England, using the Capital Asset Pricing Model to assess its capital structure. Several assumptions were made and explored in the study as part of the Capital Asset Pricing Model. The equity beta used to calculate the cost of equity under CAPM was then ungeared to produce the company's asset beta, and the distinctions between the two betas were thoroughly explained. For investors, a company's dividend policy is critical since it determines how much of the company's earnings will be reinvested in growth initiatives. The third section of the report is focused towards discussing the dividend policy of the company using ratios like, dividend per share, dividend yield, and payout ratio over the past five years. There are multiple methods of estimating the cost of equity of a company based on several assumptions and market available data. The final portion of the report compares the cost of equity of the company calculated using CAPM model and the dividend growth model and discusses about the suitability of each method upon the investment appraisal process of the company.

Capital Asset Pricing Model is an asset valuation technique which utilizes three variables to price assets and is used by multiple investors around the world to determine the required rate of return from different risky assets (Bao, Diks & Li, 2018). Capital Asset Pricing Model was developed by Nobel laureate named William Sharpe who proposed the theory in his book Portfolio theory and capital markets published in 1970 (Zakharkina & Abramchuk, 2018). The primary assumption of the theory is that an investment or an asset has only two types of risks which are discussed below:

Systematic risk – These are the risks which are associated with the overall market and it is bored by each and every sector and individual asset. Systematic risk cannot be diversified away by investing in a variety of asset classes. The systematic risk of a stock can be measured using beta of the stock which represent the sensitivity of the stock price with the price of the market (Puspitaningtyas, 2018).

Unsystematic risk – The systematic risk is the type of risk which are specific to a stock and can be influenced at the company level. It can be referred to as the portion of risk which cannot be explained by the movement in the stock market. Unsystematic risk of a stock can be diversified by investing into different sectors and industry which reduces the variance of the investment (Sukrianingrum & Manda, 2020).

Calculation of the cost of equity of Sage Group using CAPM

The formula for CAPM establishes a relation between the return expected from the asset with the systematic risk inherent in the stock. The following is the formula for CAPM used for calculating the required rate of return of a stock:

Where, Ra represents the required return from the stock based on CAPM.

Ba representing the beta of the stock.

Rm representing the return of the market in which the company is listed in.

Rf representing the risk-free rate of return in the country.

The cost of equity of the Sage Group was calculated using the above-mentioned formula and the assumptions for each variable are discussed below:

Risk-free rate of return – While making an investment decision, investors look for a benchmark return for comparing the expected return from the asset chosen for investment. Risk-free rate of return act as the benchmark return over and above which an investor wishes to earn from the asset. For the purpose of calculating required rate of return using the CAPM, the risk-free return is the primary input and the yield on government bonds of the country may act as the proxy for risk-free rate of return (Bach, Calvet and Sodini, 2020). As the Sage group is listed in England, the yield on 10-year UK government bond has been taken as the proxy for risk-free rate of return. The yield for the 10-year UK government bond was equal to 1.89 percent.

Market return premium – Market risk premium is the difference between the returns provided by the market portfolio of the economy and the risk-free rate of return and it is also determined by ascertaining the slope of the security market line. The premium is the difference between an equity market portfolio and yields on government bonds and it may reflect the required returns, historical returns and the expected returns (Fernandez, 2017). The premium based on historical returns would be same for all type of investors whereas the premium which is based on expected returns would differ according to the risk tolerance and style of investing. The past 10-year average return on FTSE 100 index of the United Kingdom was taken as the proxy for market premium which was then deducted from the risk-free rate of return to arrive at a risk premium equal to 5.49 percent.

Beta of the stock – The beta of the stock measures the sensitivity of the stock price with the movement in the price of the index or the market portfolio. If the beta of a stock is more than 1 it is said to be more volatile than the market as a change of 1 percent in the price of the market would instigate a change of more than 1 percent in the price of the stock. A stock with a low beta is generally warranted by investors as it ensures that the stock is less correlated with the movement in the market and it would act as a diversifier if it is included in a portfolio (Yang & Hu, 2021). The beta of Sage Group was taken from Yahoo finance and it was equal to 0.60 depicting that the stock of the company is less volatile to the movements in the market.

Dividend policy analysis of Sage group

The following table represents the cost of equity calculated for the company:

Risk free rate of return

1.89%

Market return (FTSE 100)

7.38%

Beta of the stock

0.6

CAPM

5.18%

The cost of equity for the Sage Group using the CAPM was estimated to be equal to 5.18 percent.

The beta of the stock was equal to 0.60 and was taken from Yahoo finance. In order to arrive at the asset beta using the equity beta of the stock, there are several financial information related to the company was required. The following is the formula to un-gear the equity beta to arrive at the asset beta of the stock:

Ba represents the asset beta of the company.

Ve is the market value of the equity of the company.

Vd represents the market value of the debt of the company.

T represents the tax rate of the company

The market value of the company’s equity was taken from sources available in the internet. To avoid complexity the book value of debt was taken in place of the market value of the debt. The tax rate of the company was calculated by dividing the tax expense of the company for the year 2021 with the profit before tax of the company for the same year. The following table summarizes the necessary information required to arrive at the asset beta of the company:

Value of equity

7365

million

Value of debt

814

million

Tax rate

17.87%

After tax value of debt

668.5591

million

After tax market value of company

8033.559

million

ASSET BETA

0.55

The asset beta of the company was calculated to be around 0.55 using the above formula. The importance of the equity beta also known as the levered beta and asset beta also known as the unlevered beta are discussed below:

Equity beta of the company refers to the volatility of the returns of the stock with respect to movement in the market price of the benchmark. Equity beta is the measurement of risk which takes into consideration the company’s capital structure including the level of leverage in the company. The more the equity beta of a company the riskier the company becomes for investment (Mulyati, 2017). The equity beta incorporates the level of debt inside the company and suggest a value which measures the sensitivity of the stock’s return.

The higher the level of debt in the company, the more income the company has to said aside to meet the interest cost related to the debt. As the level of debt keeps on increasing in the company the volatility of the earnings in the future periods also keeps on increasing (Marsden, 2018). This cause an increase in the level of risk of the company but it is not related to the assets of the company. As a result, asset beta captures the risk of the firm by excluding the influence of financial leverage and measuring the risk that is only linked with the company's assets. The company's asset beta was found to be 0.55, which is slightly lower than the equity beta.

Dividend payout policy can be considered as one of the most important decisions that a company has to take to determine the amount of earnings that needs to be re-invested back into the business and the amount of earnings that needs to be paid out to the shareholders. If a company makes profit, it has to decide the amount of earnings that needs to be paid to shareholders which might encourage the investors to buy the stock of the company (Baker & Weigand, 2015). Preferred dividends are delivered to preference shareholders first and have priority in receiving dividends; while common dividends are distributed to ordinary stockholders after the preference stockholders have received their dividends. A company may decide to pay dividend at different point of times in a financial year. Generally, dividends are paid out quarterly, half-yearly and annually. There are different types of dividend policies that a company adopts and some of them are discussed below:

  • Stable dividend policy – Stable dividend policy can be defined as a policy where a company decides to pay equal amount of dividend every year irrespective of the earnings of the company and the financial performance of the company. Hence, a company adopting this dividend policy, the company is bound to maintain the equal level of dividend every year in order to avoid giving negative signals to the market about the company’s prospects (Benlemlih, 2019).
  • Residual dividend policy – This is the type of dividend policy where a company decides to pay out the earnings of the company to the shareholders after it has invested the required amount of capital for growth projects. This type of policy gives the company flexibility to get its hands on internally generated capital and the remaining earning can be distributed to the shareholders.
  • Regular dividend policy - The term "regular dividend policy" refers to a dividend policy in which a business pays out same quantity of cash each year and commits to a value tell for multiple years. Under this dividend policy, the firm would be required to match its payout ratio to the increase in earnings.
  • Progressive dividend policy - This is a policy in which corporations strive to increase their dividend payout every year in order to align the dividend growth with the company's long-term profits growth. Hence, the amount of dividend keeps on growing year by year based on the growth of earnings of the company per year (Vasiljeva, 2017).
  • Irregular dividend policy - When a company maintains this payout strategy, it will be ready to provide special shareholder dividends. Shareholders get special dividends with the disclaimer that they have been paid owing to extraordinary situations but may not be paid again in the term. Nonetheless, the corporation may be able to deliver profits to stockholders of a monthly dividend (Kanakriyah, 2020).

Comparison of cost of equity using CAPM and dividend growth model

The following section highlights the dividend paid by the company since the starting of the year 2017 till 2021.

Source – hl.co.uk

The dividend of the company has been growing across the period of five years starting with a dividend of 15.42p in the year 2017 reaching the level of 17.68p in the year 2021. The company seems to have been following progressive dividend policy with the amount of dividend growing in line with the earning per share of the company. The following table demonstrates the dividend growth rate of the company from the year 2017 till 2021:

Year

2021

2020

2019

2018

2017

Dividend growth

2.49%

2.01%

2.48%

7%

8.98%

Source – hl.co.uk

The dividend growth of the company was the most in the year 2017 where the dividend grew by around 8.98% followed by a growth of 7% in the year 2018. The dividend growth rate fell significantly to the level of 2.48% in the year 2019. The dividend growth rate for the year 2020 and 2021 was equal to 2.01% and 2.49% respectively. The following table represents the dividend yield of the company along with the dividend cover of the company for the past five years:

Year

2021

2020

2019

2018

2017

Dividend yield

2.50%

2.40%

2.40%

2.80%

2.20%

Dividend cover

1.31

1.59

1.68

1.97

1.96

Source – hl.co.uk

For the previous five years, the company's dividend yield has been quite consistent, ranging from 2.40 percent to 2.50 percent. With a dividend yield of 2.80 percent, 2018 was the year with the highest dividend yield. In 2017, the corporation was able to generate 1.96 times the amount of dividend it paid out in 2017. The corporation had no trouble sustaining a profit per share that was adequate to cover the dividend payments each year. However, the dividend cover ratio has been continuously declining since 2018, with a coverage ratio of 1.97 in 2018 and a level of 1.31 in 2021.

As we had discussed earlier, The Capital Asset Pricing Model is a three-variable asset valuation approach that is used by many investors across the world to assess the needed rate of return from various hazardous assets. There are multiple other methods of calculating the cost of equity, one of them is the dividend growth model of estimating cost of equity.

CAPM model assumes that the stock’s return can be influenced only by market related factors and not factors related to the stock. The CAPM model uses inputs from the market available data like the market return, the risk-free rate of return and the beta of the stock which measures the sensitivity of the stock with respect to the market. The CAPM model predicted a value of around 5.18 percent in the calculations that have been demonstrated in Part B. The CAPM may be a useful model as it accounts for the risk inherent in the conduct of the company and investors can decision based on the analysis of the inherent risks. Although, despite being a famous cost of equity calculation model, the CAPM method have been modified to add certain factors apart from the market factor which deemed to be appropriate

The dividend discount model on the other hand measures the cost of equity of the company based on the dividend history of the company. This method can be utilized only for those companies which have a proven track record of dividends over the past decade. To arrive at an appropriate cost of equity value using the model, three primary inputs are required to calculate the required return. To calculated the growth rate of the dividend, the compounded annual growth rate of the company was ascertained using the dividend paid data for the past five years. The stock price of the company in the month of April 2022 was taken as an input to be used in the model. The following is the formula for calculating cost of equity using DDM model:

Conclusion

Re = D1/P0 + g

The table below highlights the figure corresponding to the each required variable:

CAGR

2.77%

D1

18.17028913

P0 (stock price)

721.5

Cost of equity

5.29%

The dividend for the first period was calculated by forecasting the dividend of the current period using the growth rate of the dividend in the past five years. The cost of equity calculated using this method was equal to 5.29%.

The dividend discount model of cost of equity estimation was deemed appropriate for the company because the primary assumption of the DDM model is that a company's dividends are expected to grow rather than be reduced or withdrawn, and the company has a proven track record of paying regular and progressive dividends to its shareholders (Jawadi & Prat, 2017).

Conclusion

The goal of this paper was to evaluate the cost of equity of Sage Group, a publicly traded software firm with headquarters in the United Kingdom. The CAPM model, its characteristics, advantages, and calculations of the cost of equity using the model are covered in the first section of the study. Based on the market return premium of the last 10-year FTSE 100 index return and the beta value of the stock retrieved from yahoo finance, the CAPM needed rate of return projected by the model was 5.18 percent. The report's second section detailed the previously calculated beta value of the stock being deleveraged, as well as determining the company's asset beta, which relates to the stock's unleveraged risks. The company's equity beta was 0.60, while its asset beta was 0.55, indicating that there was not much of a difference between the two. It may be determined that the corporation did not have worrying amounts of debt that would have influenced the equity beta. The report's third section examines the many sorts of dividend policies used by corporations all around the world. The corporation has a progressive dividend policy, with the payout amount increasing in tandem with the increase in earnings per share. The article wraps up with a review of cost of equity metrics such as CAPM and the Dividend Growth Model. Both techniques produced a cost of equity that was quite near to each other, but because the firm has consistently followed a progressive dividend policy, the dividend discount model's cost of equity is the most appropriate for the company.

References

Bach, L., Calvet, L. E., & Sodini, P. (2020). Rich pickings? risk, return, and skill in household wealth. American Economic Review, 110(9), 2703-47.

Baker, H.K. & Weigand, R., 2015. Corporate dividend policy revisited. Managerial Finance.

Bao, T., Diks, C., & Li, H. (2018). A generalized CAPM model with asymmetric power distributed errors with an application to portfolio construction. Economic Modelling, 68, 611-621.

Benlemlih, M. (2019). Corporate social responsibility and dividend policy. Research in International Business and Finance, 47, 114-138.

Fernandez, P. (2017). CAPM: The Model and 307 Comments About It. Available at SSRN 2523870.

Jawadi, F., & Prat, G. (2017). Equity prices and fundamentals: a DDM–APT mixed approach. Review of Quantitative Finance and Accounting, 49(3), 661-695.

KANAKRIYAH, R. (2020). Dividend policy and companies' financial performance. The Journal of Asian Finance, Economics, and Business, 7(10), 531-541.

Kumar, S., Colombage, S., & Rao, P. (2017). Research on capital structure determinants: a review and future directions. International Journal of Managerial Finance.

Marsden, A. (2018). Asset Beta for Notional Processor: Response to the CEPA Report dated 16 July 2018 and the Commerce Commission’s “Review of Fonterra’s 2017/18 base milk price calculation: Dairy Industry Restructuring Act 2001”.

Mulyati, Y. (2017). The influence of voluntary disclosure, stock beta, and firms size on cost of equity capital. Jurnal Keuangan dan Perbankan, 21(3), 387-396.

Puspitaningtyas, Z. (2017). Estimating systematic risk for the best investment decisions on manufacturing company in Indonesia. Investment management and financial innovations, 14(1), 46-54.

Sukrianingrum, D. R., & Manda, G. S. (2020). The effect of systematic risk and unsystematic risk on expected return of optimal portfolio.. SAR (Soedirman Accounting Review): Journal of Accounting and Business, 5(2), 181-195.

VASILJEVA, M. V. (2017). The effect of dividend policy on company’s market price per share. Journal of Applied Economic Sciences (JAES), 12(50), 995-1007.

Yang, C., & Hu, X. (2021). Individual stock sentiment beta and stock returns. The North American Journal of Economics and Finance, 55, 101306.

Zakharkina, L. S., & Abramchuk, M. Y. (2018). Correctness of the CAPM-Model application in the Ukrainian reality in terms of investors financial security.

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