Internal consistency of risk free rate and MRP in the CAPM

171. Combining my best estimate of the historical average real required return on 10 year
CGS with a beta of 0.8 and an MRP of 6.0% gives a real cost of equity of 8.20%. If
expected inflation going forward is 2.50% then a 5.99% nominal CGS yield is required
to deliver the same 3.40% real yield. Using this nominal CGS yield with a beta of 0.8
and an MRP of 6.0% gives a nominal cost of equity of 10.78%.
172. The 6.0% MRP estimate used above is the estimate most commonly used by
Australian regulators over the period in relation to which the yields on CGS have been
averaged. If the use of a 6.0% MRP over this period was, on average, correct then it
is consistent and appropriate that an average CGS yields over this period be added to
it.
173. While the genesis of the 6.0% MRP estimate may be based on the average of a longer
time series of historical ex post returns on equity relative to CGS, I do not consider that
this makes it problematic to use a shorter time series for historical average ex ante real
return on CGS.
174. There are two reasons why I hold this view:
� Firstly, we are interested in estimating the ex ante real risk free rate (i.e. the
expected return for investors after accounting for inflation). This can be estimated
with much greater accuracy from the early 1990s onwards due to the introduction
of inflation indexed bonds which allow us to directly estimate the real CGS yield
actually required by investors over that period; and
� Secondly, and by contrast, historical average estimates of MRP must be based on
very long time periods because the volatility in the observed ex post excess return
on equities is so large that a long period is required in order to have any
confidence in the average reflecting ex ante investor expectations (ie, the excess
return investors needed to expect in order to invest). This is not the case with
indexed CGS where the promised real yield is the real yield actually delivered.
Nor is it the case with nominal CGS in a low and stable inflation environment such
as has existed in the post 1993 period of inflation targeting by the RBA.
7.3.1.2. Cross checks on the historical average cost of equity estimate
175. An additional potential source of information on normal required returns for regulated
businesses comes from US regulatory precedent involving the application of the DGM
model. For the US regulatory decisions from 2005 to 2011 described previously, I
have estimated the average ROE is 10.38% (11.01% over the last 20 years). The
average equity premium is 6.57% and average 10 year US Treasury rate is 3.80%.
Note that this is based on DGM analysis performed by regulators. However, this is for
an average gearing of 47.98%. Adjusting this to 60% gearing gives an average cost
of equity of 12.36%. 56
56 12.36% = 3.805% + (1-0.4798)/(1-0.600)*6.575%
Competition Economists Group
www.CEG-AP.COM
46