Thecostofequityistherateofreturnthatinvestorsrequireto
makeanequityinvestmentinafirm.Alloftheriskandreturn
models described in the preceding section need a risk-free rate
andariskpremium(intheCAPM)orpremiums(intheAPM
andmultifactormodels).Wewillbeginbydiscussingthose
commoninputsbeforeweturnourattentiontotheestimation
of betas.
Risk-Free Rate
Mostriskandreturnmodelsinfinancestartoffwithanasset
thatisdefinedasriskfreeandusetheexpectedreturnonthat
asset as the risk-free rate. The expected returns on risky
investmentsarethenmeasuredrelativetotherisk-freerate,
withtheriskcreatinganexpectedriskpremiumthatisadded
on to the risk-free rate.
Determining a Risk-Free Rate
Wedefinedarisk-freeassetasonewheretheinvestorknows
the expected return with certainty. Consequently, for an
investmenttobe riskfree(i.e.,to havean actualreturnbe
equal to the expected return), two conditions have to be met:
1.Therecanbenodefaultrisk,whichgenerallyimpliesthat
thesecurityhastobeissuedbyagovernment.Note,though,
thatnotallgovernmentsaredefaultfreeandthepresenceof
government or sovereign default risk can make it very
difficult to estimate risk-free rates in some currencies.
- There can be no uncertainty about reinvestment rates,
whichimpliesthattherearenointermediatecashflows.To
illustratethispoint,assumethatyouaretryingtoestimatethe