Equity #30 - Return Concepts

Question 1

equity risk premium (ERP)

Answer 1

LOS 30.b

• equity risk premium (ERP) - additional return above risk-free rate investors require for holding risky equity securities

ERP = R_req - R_f

Question 2

required return for a stock

Answer 2

LOS 30.b

• use ERP and beta (i.e. level of systematic risk component for the stock) to determine the required return for the stock

R_i = R_f + ß(R_M - R_f)

• risk-free rate should be equal to the investor’s investment horizon
  
  • T bills for short horizon
  • T bonds for longer holding periods

Question 3

IRR (def)

Answer 3

LOS 30.a

IRR is the discount rate needed to make DCF equal the current price

Question 4

required return for stock “j”

Answer 4

LOS 30.b

required return for stock “j” = risk-free premium + equity risk premium + other adjustments for j

R_j = R_f + ßR_prem + b(other factor)

Question 5

what does “ex ante” mean?

Answer 5

LOS 30.b

“forward-looking”

Question 6

3 types of ex ante estimates of the equity risk premium

Answer 6

LOS 30.b

• Gordon Growth Model (GGM)
• macroeconomic models - use current info, but are appropriate only for developed countries where public equities represent a relatively large share of the economy
• survey estimates - easy to obtain, but can have wide disparity between opinions

Question 7

models used to estimate the required return on equity

Answer 7

LOS 30.c

• CAPM: R_j = R_f + ßR_prem
• Multifactor model: R_j = R_f + R_prem1 + R_prem2​ + … + R_premn​
• Fama-French model:
  R_j = R_f + ß_mkt,j(R_mkt - R_f) + ß_SMB,j(R_small - R_big​) + ß_HML,j(R_HBM - R_LBM​),
  HML = “high minus low B/M value”, HBM = “high B/M”, LBM = “low B/M”
• Pastor-Stambaugh model: Fama-French plus a liquidity factor and prem
• Build-up method: R_j = R_f + equity Rprem + size prem + firm-specific prem

Question 8

steps for estimating beta for thinly-traded and non-public companies

Answer 8

LOS 30.d

For analyzed company “j”:

1. identify publicly-traded benchmark company: “k”
2. estimate beta of the benchmark company: ß_k
3. unlever the benchmark company’s beta:
   ß_unl,k = ß_k[1/(1+D_k/E_k)], D_k/E_k = debt-to-equity ratio for k
4. relever beta using capital structure of the company being analyzed:
   ß_j = ß_unl,k(1+D_j/E_j), D_k/E_k = debt-to-equity ratio for j