Contrast the approaches for estimating equity investors' required return
The idea
The capital asset pricing model sets the required return at r = risk-free rate + beta × equity risk premium. Multifactor models add premiums for exposures such as size, value or liquidity. The build-up approach, common for private firms, adds to the risk-free rate the equity risk premium plus size and company-specific premiums; an expanded CAPM does the same using a beta. The bond-yield-plus-risk-premium approach adds a judgemental premium, often a few percentage points, to the yield on the company's own long-term debt, so it needs traded debt. Each method has weaknesses: beta estimation error, judgement in premiums. The trap is adding the premium to the government yield in the bond-yield approach.
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- Set out the top-down and bottom-up influences on a firm's cost of capital
- Contrast the approaches for estimating what debt costs a firm
- Set out how an equity risk premium can be estimated from past data or from forward-looking inputs
- Work out the cost of debt or equity investors' required return for both a listed and a privately held company
- Benchmark a company's cost of capital and capital structure against those of its peers