Expected return, stock valuation, and the capital structure: comparing the Gordon model and the capital asset pricing model

Expected returns, stock valuation methods, and capital structure management have a major influence on the effectiveness of the company’s financial strategy. This study analyzes a sample portfolio to consider how the expected rate of return is assigned, how common stock is valued, and how equity and debt are targeted in the firm’s capital structure. The validity of an algorithm that values common stock depends on accurate assessment of the expected return. Company policy for acquiring capital and paying dividends could alter the expected return. The capital asset pricing model (CAPM) helps judge the role of certain factors in determining expected return and stock value. In the sample portfolio, we shall work with one valuation method, the Gordon Model of constant growth, and compare its expected returns with the CAPM. The CAPM considers the risk-free rate, the market risk premium, and a systematic risk index, while the Gordon Model assigns value of stocks based on dividend growth. We examine dividend payout policy to find that it influences differences between the Gordon Model and the CAPM’s expected returns. Both methods help determine how the cost of equity may be applied to the firm’s capital structure, usually in the weighted average cost of capital (WACC). Tax factors in the WACC influence the proportions of debt and equity in the capital structure. The tax benefit of debt makes debt the least expensive source of capital funding, but its use should be limited due to the higher risk of debt. Manipulations within the WACC have an influence on the mix of funding sources in the capital structure, the cost of both debt and equity, and the stock price. Therefore, the discussion will further consider the topic of capital structure optimization. This previously unpublished paper is the original work of the author.