Posted: September 9th, 2022

About IRR and the estimation of cost of equity

Course: FIN420 Section
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Subject: RE: About IRR and the estimation of cost of equity

Dear CEO,
Capital budgeting technique is basically a process in which most companies use to authorize the expenditure of capital on projects that requires a significant expenditure on capital. Projects that require huge expenditure of capital are evaluated using both qualitative and quantitative methods because capital has a limited liability. The cost of equity refers to the output the stakeholder will get after investing in a company. This paper will explain why the Internal Rate of Return is not the best budgeting technique, and offer a comparison between the dividend growth model and market line approach in regards to estimation of cost of equity.
Limitations of Internal Rate of Return
Internal Rate of Return is describes the ratio at which the present value of capital investment is zero. This means that the cash outflow is equal to the cash inflow. Although this technique has various advantages over other techniques, it is however not the best budgeting technique. One of the reasons to as why it’s not the best is because the technique involves calculations that are very tedious and time-consuming and this makes it prone to errors. The method is not the best since it only take into consideration the profitability and assumes the earliest time of recouping from the capital expenditure. This is because the Internal Rate of Return technique only favors projects that requires a relatively long time for recouping of the capital expenditure. At times the future is always full of uncertainty and this makes it impossible for recouping the capital expenditure.
Dividend Growth Model vs Market Line Approach
There are various similarities and differences between the dividends growth model and security market line approach in stock estimation. The security market line can be described as a line drawn on a graph to make a representation of the price of capital assets. It depicts the level market or the risks of various securities that are plotted against the returns. The Dividends growth model is used a method of realizing the true value of the stock and this is based on the returns. In both models, there is a return. The dividends growth model earns dividends for the firm whereas the security line model earns the firm profits. Both models assess the cost of stocks. In Security market Line, you only run the risk of making the market sluggish or weakened and can also drag your stock down. This can happen even if you diversify all your stocks. The dividends growth is different since the only risk that the firm has is that of not making more money. The dividends are also not reduces although the stocks might go down. Another difference is that in security market line, the firm should hold the stocks for long so that the price can increase but in dividends growth, dividends are realized after a short period.
Conclusion
Internal Rate of Return is not always the best method of budgeting because of its numerous flaws as compared to other methods. The method doesn’t change thus it’s not the best option for projects with a longer timeline. Stakeholders need to analysis the cost of equity before investing in a business. This can be done by carefully analyzing the differences and similarities of the different models involved.
Kind Regards,
[Your Name]

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