To estimate cost of equity, letís consider 3 models:
1) The Capital Asset Pricing Model
2) The discounted cash-flow method
3) The over-own-bond-yield-plus-judgmental-risk-premium approach
To estimate the cost of common stock using CAPM we need to proceed the following steps:
1) To estimate the risk-free rate.
We canít truly find riskless rate upon which to base CAPM, so itís common to use rate on 10-Year T-bonds as risk-free rate.
2) To estimate the market-free risk premium.
The market risk-free premium is not directly observable, so there are different approaches to estimate the market risk premium.
Historical risk premium
We calculated historical market risk premium, using the data from 1982 to 2011 year of S&M 500 annual market return and 10-year U.S. T-bonds. RPm =5, 86
Forward-Looking Risk Premium = 4,4%
An alternative to the historical risk premium is ex ante risk premium. In this model we use forward-looking data. According to the model, the market is in equilibrium, so required rate of return = expected rate of return. We obtain the marketís actual dividend yield by using estimation for the S&P 500 reported dividend Yield in October 2012 = 2,07%
Constant dividend growth rate is calculated the following way:
A. I-rate on 10-year T-bonds=3.2% -1,69%=1,53%
B. Expected inflation will be somewhere between 1,52% and historical average inflation (3%)
C. Reasonable estimate of sustainable population growth is from 1% to 2,5%
D. Combine long-term population growth with expected inflation suggests that long-term constant growth rate is around 2,52% to 5,5%
According to the recent surveys of professionals ďMarket Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 AnswersĒ, the average market risk premiums in U.S. in 2012 from a broad survey of professors, analysts and companies equals to 5, 5% (RPm3).
We believe that the estimate of market risk premium by survey experts is the most appropriate as it takes into consideration many factors.
3) The next step of our CAMP model is to estimate beta. The beta is estimated to be 1, 17 (PartĻ3)
Thus, according to CAPM model, and using different approaches to the estimation of market risk premium, cost of equity is:
Rs1= 1, 68%+ 5,86%*1, 17= 8.54%
Rs2= 1, 68%+ 4, 4%*1, 17= 6, 83%
Rs3= 1, 68%+ 5, 5%*1, 17= 8,12%
Outcome: for the further use of the cost of common stock, using CAPM model itís rational to use Rs3, because it includes RPm, estimated by the specialists. Historical risk premium is not enough appropriate for the estimation of the current risk premium. As stocks returns are quite volatile, it leads to the low confidence in the estimated averages. Moreover historical average is extremely sensitive to the period over which it is calculated. And our estimation of market risk premium for g2 canít be seen as reliable, as it relies 2 unrealistic assumptions that our Company will not repurchase any stocks and the growth in the dividend will be constant (actually itís not constant for Disney).