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The following is written in the text
ARR on equity (r used in Gordon’s growth model)
“The weakness of the ARR as a measure of return is that:
• it ignores the level of investment in intangible assets
• in the long run, the return on new investment tends to the cost of
equity.
Hence, if a short term growth rate is required, the ARR provides a fair
approximation for use in the growth model. However, if a long term
growth rate is needed, ke should be used as the percentage return. To
avoid a recursion problem, this should be derived using CAPM.”I didnt understand this sir
Can you pls explain this with clarity
Thank youI don’t know which text you are referring to, but what is written is all a bit ridiculous and is not relevant for the exam.
r in the growth model is the shareholders required rate of return, because it is this that determines the market value of equity.
Identifying the shareholders required rate of return in practice is a problem, but given that the required return depends on the level of risk then it is the equity beta that we use to determine the required return.
This is the Kaplan Text
What I understood from your response
(1) Ignore whatever is written…Right?
(2) r= Shareholders required return. As its difficult to find it in practice…we’ll use the equity beta to find Ke and Ke will be the r in the growth model…Am i correct?
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