CP

Comparison of the CAPM, DCF, and Bond-Yeild-plus-Risk-Premium Methods 237

Evaluating the Methods for Estimating Growth

Note that the DCF approach expresses the cost of common equity as the dividend

yield (the expected dividend divided by the current price) and the growth rate. The

dividend yield can be estimated with a high degree of certainty, but the growth esti-

mate causes uncertainty as to the DCF cost estimate. We discussed three methods: (1)

historical growth rates, (2) retention growth model, and (3) analysts’ forecasts. Of

these three methods, studies have shown that analysts’ forecasts usually represent the

best source of growth rate data for DCF cost of capital estimates.^10

Bond-Yield-plus-Risk-Premium Approach

Some analysts use a subjective, ad hoc procedure to estimate a firm’s cost of common

equity: they simply add a judgmental risk premium of 3 to 5 percentage points to the

interest rate on the firm’s own long-term debt. It is logical to think that firms with

risky, low-rated, and consequently high-interest-rate debt will also have risky, high-

cost equity, and the procedure of basing the cost of equity on a readily observable debt

cost utilizes this logic. For example, if an extremely strong firm such as BellSouth had

bonds which yielded 8 percent, its cost of equity might be estimated as follows:

rsBond yield Risk premium 8% 4% 12%.

The bonds of NCC, a riskier company, have a yield of 10.4 percent, making its esti-

mated cost of equity 14.4 percent:

rs11% 4% 15%.

Because the 4 percent risk premium is a judgmental estimate, the estimated value

of rsis also judgmental. Empirical work suggests that the risk premium over a firm’s

own bond yield has generally ranged from 3 to 5 percentage points, so this method is

not likely to produce a precise cost of equity. However, it can get us “into the right

ballpark.”

What is the reasoning behind the bond-yield-plus-risk-premium approach?

Comparison of the CAPM, DCF, and

Bond-Yield-plus-Risk-Premium Methods

We have discussed three methods for estimating the required return on common

stock. For NCC, the CAPM estimate is 14.6 percent, the DCF constant growth esti-

mate is 14.5 percent, and the bond-yield-plus-risk-premium is 14.4 percent. The

14.5%.

7.5%7.0%

rˆsrs

$2.40

$32.00

7.0%

(^10) See Robert Harris, “Using Analysts’ Growth Rate Forecasts to Estimate Shareholder Required Rates of
Return,” Financial Management, Spring 1986, 58–67. Analysts’ forecasts are the best predictors of actual
future growth, and also the growth rate investors say they use in valuing stocks.

234 The Cost of Capital