Fight Finance

Question 248  CAPM, DDM, income and capital returns

The total return of any asset can be broken down in different ways. One possible way is to use the dividend discount model (or Gordon growth model):

$$p_0 = \frac{c_1}{r_\text{total}-r_\text{capital}}$$

Which, since $c_1/p_0$ is the income return ($r_\text{income}$), can be expressed as:

$$r_\text{total}=r_\text{income}+r_\text{capital}$$

So the total return of an asset is the income component plus the capital or price growth component.

Another way to break up total return is to use the Capital Asset Pricing Model:

$$r_\text{total}=r_\text{f}+β(r_\text{m}- r_\text{f})$$

$$r_\text{total}=r_\text{time value}+r_\text{risk premium}$$

So the risk free rate is the time value of money and the term $β(r_\text{m}- r_\text{f})$ is the compensation for taking on systematic risk.

Using the above theory and your general knowledge, which of the below equations, if any, are correct?

(I) $r_\text{income}=r_\text{time value}$

(II) $r_\text{income}=r_\text{risk premium}$

(III) $r_\text{capital}=r_\text{time value}$

(IV) $r_\text{capital}=r_\text{risk premium}$

(V) $r_\text{income}+r_\text{capital}=r_\text{time value}+r_\text{risk premium}$

Which of the equations are correct?

(a) I, IV and V only.

(b) II, III and V only.

(c) V only.

(d) All are true.

(e) None are true.