f. What is the cost of equity based on the over-own-bond-yield-plus-judgmental-r

Question

f. What is the cost of equity based on the over-own-bond-yield-plus-judgmental-risk-premium method?

THE BOND-YIELD-PLUS-JUDGMENTAL-RISK-PREMIUM APPROACH
This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that the risk premium for equity is in the range of 3 to 5 percentage points. This method provides a ballpark estimate, and it is generally used as a check on the CAPM and DCF estimates. This method is used primarily in utility rate case hearings.




Over-own-bond-judgmental risk premium = 3.2%
Bond yield = 10.0%

rs = Judgmental premium + Own bond yield

rs = 3.2% + 10.0%
rs = 13.2%

Explanation / Answer

This over-own-bond-judgmental-risk premium is NOT EQUAL TO CAPM equity risk premium, RPM.

Estimate of Rs

METHOD

ESTIMATE

CAPM

12.8%

DCF

12.4%

Rd +judgement

13.2%

averge

12.8%

METHOD

ESTIMATE

CAPM

12.8%

DCF

12.4%

Rd +judgement

13.2%

averge

12.8%

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