According to the capital asset pricing model: E(R_i) = R_F + [E(R_M)-R_F]beta_i

Question

According to the capital asset pricing model: E(R_i) = R_F + [E(R_M)-R_F]beta_i Wher E(R_i), the expected return on security i, is the sum of R_F, the return on a risk Free investment, and [E(R_M) - R_F] beta_i is the expected extra return over the risk-free for taking on the risk of holding the security. Beta_i measures the relative sensitivity of security's returns to changes in the return of a market index. E(R_M) is the expect return on a market index, and [E(R_M) - R_F] is the difference between the expect market return and risk-free rate, otherwise known as the market risk premium

Explanation / Answer

The market risk premium is the expected return on the market portfolio of risky assets less the return on the risk-free asset. The market risk premium reflects the return that investors require to accept the uncertain outcomes associated with investment, relative to the returnprovided by a risk-free asset.

CEG attributes these materially lower estimates to the ‘mechanical’ way in which the AER (and other Australian regulators) set the cost of equity for regulated firms, namely that regulators set:

(a) the risk-free rate (the first term in the CAPM) equal to the relevant, current government bond rate; and

(b) the market risk premium based on the AER’s estimate of the historical average risk premium earned by Australian equity investors, which, by construction, is very stable.

Therefore, as the two parameters enter the CAPM as per equation (1), if the risk-free rate fluctuates significantly and the market risk premium is stable then, for a given beta estimate, the cost of equity moves in line with the risk-free rate (CEG, 2012: 5-6). That is, given that regulators apply a ‘stable’ market risk premium, if the risk-free rate is low (high), the cost of equity will be low (high). In reference to this (i.e. the AER’s) methodology, CEG states:

The implication of this set of claims is that the current regulatory approach to setting the allowed cost of equity by ‘passing through’ unusually low risk-free rates, without changing the market risk premium, will lead to a cost of equity that is too low at the present time and, therefore, result in under-compensating the regulated firms. On the assumption that standard regulatory practice will lead to under-compensation, CEG then proposes three alternative methods (relative to the AER’s methodology) for estimating the cost of equity given current market conditions 20 Specifically, CEG proposes three alternatives to the ‘standard’ regulatory approach of coupling a current risk-free rate with a ‘long term’ market risk premium, namely applying the:

(a)Firm-specific Dividend Growth Model: the model is applied to each of six Australian regulated firms, with the model estimating a cost of equity consistent with current share price, the current dividend level, and estimates of future expected dividends per share – with this model, estimates of the average cost of equity vary from 10.87% to 14.59% 21;

(b) Long Term Average Risk-free Rate with a Long Term MRP – the method adds a 20-year average risk-free rate of 5.99% to a ‘long term’ market risk premium of 6.0%; in combination with an assumed equity beta of 0.80, these parameters result in a cost of equity of 10.78%; and 22

(c) Market-level Dividend Growth Model: the model is comparable to the model in (a) but applied to the market as a whole using ‘market’ estimates of the various parameters to obtain a market risk premium of 8.52%; in combination with an assumed equity beta of 0.80, the resulting cost of equity is 10.58%

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