Internal consistency of risk free rate and MRP in the CAPM

8. Conclusion
181. There is unambiguous evidence that risk premiums in the market for funds have risen
to offset the recent fall in CGS yields. The effect of this is that the prevailing cost of
equity is at least as high as under normal market conditions – notwithstanding that the
CGS yields are at 50 year lows. In these circumstances, it would be an error to
estimate the cost of equity using prevailing CGS yields in combination with a historical
average estimate of the market risk premium.
182. Alternative methodologies consistent with Rule 87(1) of the NGR and section 24(2)
and (5) of the NGL involve estimating the cost of equity using:
i. A DGM estimate of the cost of equity for firms which experience risks that are
comparable to those confronted by firms which provide the reference services.
ii. DGM estimates of the cost of equity for the market portfolio ( ) and a
separate process for estimating the adjustment for differences in risk between the
market and the reference services (a beta different to 1.0).
iii. Estimate a ‘normal’ level for the cost of equity for the reference services and make
an adjustment to that based on evidence/proxies that suggest
heightened/depressed prevailing conditions in the market for funds relative to
‘normal’ conditions.
183. Any of these approaches will, in my view, result in an estimate of the cost of equity that
is at least 10.58%. This is around 2% more than is estimated using prevailing CGS
yields in conjunction with the AER’s most recently used estimates of the MRP (6%)
and equity beta (0.8) estimates.
Competition Economists Group
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