In comparing the constant growth model and the capital asset pricing model (CAPM) to calculate the cost of common stock equity,
A) the constant growth model ignores risk, while the CAPM directly considers risk as reflected in the beta.
B) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses the market price as a reflection of the expected risk-return preference of investors.
C) the CAPM directly considers risk as reflected in the beta, while the constant growth model uses dividend expectations as a reflection of risk.
D) the CAPM indirectly considers risk as reflected in the market return, while the constant growth model uses dividend expectations as a reflection of risk.

Question

Quizplus · Accepted Answer

The constant growth model estimates the cost of equity based on the expected growth rate of dividends and is not directly related to the level of risk. On the other hand, the CAPM calculates the cost of equity by considering the risk of the investment as reflected in the beta. Therefore, option B is correct. Option A and C do address the difference in the consideration of risk, but the description is inaccurate. Option D is incorrect because the constant growth model uses dividend expectations to reflect company growth, not risk.

In Comparing the Constant Growth Model and the Capital Asset