“Understanding Risk Premium- An important step to calculate Cost of Equity”

It has been long time since I came out with a blog. Today, I am going to concentrate on Risk premium. The CAPM model which is basically used to quantify the market risk in the form of market return consists of two things which is given by

Ke = Risk free rate + Risk premium

= Rf  + ( Rm – Rf )

The second value basically speaks about the premium that an investor expects from his investment for taking extra risk to invest in the stock of a particular company. The most simple step to calculate risk premium is to subtract ( Rf) from expected market return ( Rm ). But the problem with this approach is that we use historical data to calculate the average value of Rm. Hence, the value changes significantly with change in sample size and the method use to find average. Secondly, the standard error also increases with increase in the standard deviation of the return as standard error is given by

S.D/ Sqrt(n)

Where n= Sample size

For example, If we calculate Rm from past 20 years data of BSE with an assumption that standard deviation is 20 %, then the value of standard error will be around 4.4 %, which is significantly large. Hence we must explore some other methods to calculate Risk premium.

Equity risk premium can also be calculated by using country risk premium. Generally, Country equity risk premium shows the value that an investor expects to get because of the extra risks that he takes compare to stable equity market. For ex, the U.S.A market is considered extremely stable. Hence, CERP for U.S.A is must be kept minimum or zero.

Country risk premium can be calculated in one of the two ways

1)      By treating the value of CERP equal to the value of default spread i.e. the extra return that an investor expects from the risk associated with country bond as compare to stable market bond as per the rating given by rating agencies But the problem with this approach is that the risk taken by equity’s investors is more than bond’s investors. Hence, CERP should be more than default spread.

2)      In order to overcome above problem we can adjust the above calculated CERP by multiplying it with ratio of standard deviation of country’s equity market and the country’s bond market.

Adjusted CERP = Default spread * ( S.D of equity market/ S.D of Bond market)

We generally use second method to calculate CERP. Hence, here onwards we use CERP in place of adjusted CERP in all the discussions. Once we calculated the CERP,  the  risk premium associated with one’s equity can be calculated in one of the following two ways:-

1)      If we assume that the risk taken by company in other country is similar to home’s country, then  Risk premium is given by

Risk premium = Beta*(CERP+ US premium)

2)      If we assume that the risk is different in different countries then,

Risk premium = Beta*(US premium) + lambda *(CERP)

Here, lambda shows the ratio of revenue earned by company in domestic market to the average revenue earned by similar’s business firm in the same market. In the above example we used US premium while calculating risk premium because we assume that the US is the most stable country and there is negligible or no risk associated with US market.

Hence, once the risk premium is calculated, add it to risk free rates to get cost of equity (Ke). Hoping, this article will help you in understanding the concept behind calculation of (Ke) by using different approaches. Kindly follow my blogs to explore the world of financial modeling and valuations.


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