Internal consistency of risk free rate and MRP in the CAPM

conditions. One can test this presumption against other evidence and, if
necessary, make an adjustment if that evidence is sufficiently compelling that the
prevailing cost of equity is heightened/depressed relative to its ‘normal’ level. The
evidence in this report suggests that if any such adjustment were to be made it
would be positive.
iv. Attempt to estimate a ‘normal’ level of the equity risk premium associated with the
reference services (i.e. a ‘normal’ level for ( )) and add this
to a prevailing estimate of the risk free rate ( ).
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- This is essentially the AER methodology. The AER estimates
( ) as the product of an equity beta estimate (derived
from historical market data) and a market risk premium figure (also derived
from historical market data). The AER then adds this to the prevailing
estimate of the risk free rate.
151. In my view, each of the first three methodologies is capable of arriving at an estimate
of the cost of equity for reference services that is consistent with the Rules across a
wide range of market circumstances. In fact, the differences between these
approaches are really ones of degree and/or emphasis. All of the first three
methodologies share the objective of deriving a forward looking (prevailing) estimate of
the cost of equity. Methodologies i) and ii) rely solely on prevailing market data to
arrive at an estimate of the cost of equity. Methodology iii) relies on historical average
data and the presumption, supported by the evidence presented in this report, that the
cost of equity is relatively stable overtime (more stable than the constituent CAPM
parameters that tend to move in offsetting directions).
152. In my view, the fourth methodology cannot be relied on to provide a robust estimate of
the prevailing cost of equity. This is because it fixes the risk premium on equity based
on historical evidence but does not similarly fix a consistent estimate of the risk free
rate. Given that risk premiums and risk free rates commonly tend to move in the
opposite direction this methodology will tend to underestimate the cost of equity when
risk free rates are low and overestimate the cost of equity when risk free rates are
high.
7.1. Methodology i)
153. The first methodology is entirely forward looking. Assuming that the CAPM describes
how investors determine prevailing conditions in the market for funds, this
methodology estimates all components of the CAPM formula jointly. Such an estimate
reflects the forward looking assessment of both market risk (MRP) and relative risk of
the reference services (beta). This approach also implicitly captures the actual risk
free rate that investors use when applying the CAPM (rather than needing to adopt a
potentially biased proxy such as CGS).
154. Of course, the first methodology does not provide estimates of the individual CAPM
parameters. However, this is a ‘feature’ and not a ‘bug’ of this approach because
these individual parameters are of little interest if we have already directly estimated
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