Intermediate Financial Management (with Thomson One)

To find the rate on a
T-bond, go to http://www
.federalreserve.gov. Select
“Economic Research and
Data,” and then select
“Statistics: Releases and
Historical Data.” Click on
“Daily” for H.15, “Selected
Interest Rates.”
324 • Part 2 Corporate Valuation
Equation 10-3 shows that the CAPM estimate of r s begins with the risk-free rate,
r RF , to which is added a risk premium set equal to the risk premium on the market,
RP M , scaled up or down to reflect the particular stock’s risk as measured by
its beta coefficient. The following sections explain how to implement the four-step
process.
Estimating the Risk-Free Rate
The starting point for the CAPM cost of equity estimate is r RF , the risk-free rate.
There is really no such thing as a truly riskless asset in the U.S. economy. Treasury
securities are essentially free of default risk, but nonindexed long-term T-bonds will
suffer capital losses if interest rates rise, and a portfolio of short-term T-bills will
provide a volatile earnings stream because the rate earned on T-bills varies over
time.
Since we cannot in practice find a truly riskless rate upon which to base the
CAPM, what rate should we use? A recent survey of highly regarded companies
shows that about two-thirds of the companies use the rate on long-term Treasury
bonds. 6 We agree with their choice, and here are our reasons:
1. Common stocks are long-term securities, and although a particular stockholder
may not have a long investment horizon, most stockholders do invest
on a long-term basis. Therefore, it is reasonable to think that stock returns
embody long-term inflation expectations similar to those reflected in bonds
rather than the short-term expectations in bills.
2. Treasury bill rates are more volatile than are Treasury bond rates and, most
experts agree, more volatile than rs . 7
3. In theory, the CAPM is supposed to measure the expected return over a particular
holding period. When it is used to estimate the cost of equity for a
project, the theoretically correct holding period is the life of the project. Since
many projects have long lives, the holding period for the CAPM also should
be long. Therefore, the rate on a long-term T-bond is a logical choice for the
risk-free rate.
In light of the preceding discussion, we believe that the cost of common equity
is more closely related to Treasury bond rates than to T-bill rates. This leads us to
favor T-bonds as the base rate, or rRF , in a CAPM cost of equity analysis. T-bond
rates can be found in The Wall Street Journal or the Federal Reserve Bulletin.
Generally, we use the yield on a 10-year T-bond as the proxy for the risk-free rate.
Estimating the Market Risk Premium
The market risk premium, RP M, is the expected market return minus the risk-free
rate. This is also called the equity risk premium, or just the equity premium. It is
caused by investor risk aversion: Since most investors are averse to risk, they
require a higher expected return (a risk premium) to induce them to invest in risky
6 See Robert E. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “Best Practices in Estimating the Cost of
Capital: Survey and Synthesis,” Financial Practice and Education, Spring/Summer 1998, pp. 13–28.
7 Economic events usually have a larger impact on short-term rates than on long-term rates. For example, see the analysis
of the 1995–1996 federal debt limit disagreement between the White House and Congress provided in Srinivas Nippani,
Pu Liu, and Craig T. Schulman, “Are Treasury Securities Free of Default?” Journal of Financial and Quantitative Analysis,
June 2001, pp. 251–266.