Internal consistency of risk free rate and MRP in the CAPM

176. This 12.36% estimate is higher than the 10.78% estimate derived immediately above.
If one accepts that US regulators application of the DGM is unbiased and that US
regulated businesses have similar underlying risk to Australian regulated businesses
then this provides a basis for concluding that the 10.78% is more likely to be too low
than too high.
177. The estimates of the cost of equity derived under methodologies i) and ii) are 10.58%
and 10.87% to 14.59% respectively. Once more, this suggests that the 10.78%
estimate is more likely to be too low than too high. Depending on the threshold
applied, one might, or might not, determine that the results of these cross checks
justified a departure from the estimate derived under methodology iii).
7.4. Methodology iv)
178. The fourth methodology is the AER’s methodology. This methodology fully reflects the
prevailing risk free rate in the cost of equity but not the prevailing risk premiums
relative to that risk free rate. In the currently prevailing market conditions this gives a
materially downwardly biased estimate of the cost of equity because, for the reasons
discussed in previous sections, it is clear that historically low CGS yields are currently
associated with historically high risk premiums.
7.4.1. Application
179. This methodology arrives at a nominal cost of equity estimate of 8.57% using end
December 2011 CGS yields of 3.77%. This is materially lower than the estimate
arrived at using all of the other methodologies.
7.5. Summary of results from different methodologies
180. Table 4 below summarises the results of the different methodologies.
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