investinginequityatanyfirm.IntheCAPM,thisexpected
return can be written as:
where the risk-freerate would be therate on a long-term
government bond, the beta would be either the historical,
fundamental,or accountingbetasdescribedearlier,and the
riskpremiumwould beeitherthehistoricalpremiumoran
implied premium. In theAPM and multifactor model, the
expected return would be written as follows:
where therisk-free rateis thelong-term government bond
rate; βj is the beta relative to factor j, estimated using
historicaldataorfundamentals;andriskpremiumjistherisk
premiumrelativetofactorj,estimatedusinghistoricaldata.
Inthissubsection,webringinsomefinalconsiderationsin
estimating the cost of equity.
Small Firms
Oncetheexpectedreturnisobtainedfromariskandreturn
model,someanalyststrytoadjustitforthemodel’sempirical
limitations.Forinstance,studiesoftheCAPMindicatethatit
tendstounderstatetheexpectedreturnsforsmallfirms.Asa
consequence,itisacommonpracticetoaddwhatiscalleda
smallfirmpremiumto obtainthecostsofequityfor small
companies. This small firm premium is usually estimated
fromhistoricaldatatobethedifferencebetweentheaverage
annualreturnsonsmallmarketcapstocksandtherestofthe