Cost of Capital

Government bond rates with equivalent terms to the cash flow terms (Important choose riskless countries)

• Theory: indefinite cash flows  bonds with indefinite term

• Practice: approximated by 20-30 year long term bonds

For the Market Risk Premium you need an Estimation of the expected MRP/ ERP… Therefore you need:

• Studies based on long term historical averages of stock returns and risk free rates

or

• Implied ERP, based on actual stock prices for „the market“ (index of stocks, e.g. EURO Stoxx 600) and cash flow and growth expectations by analysts for that index stocks.

Historical Data

Using historical stock-bond spreads for MRP, typically between 4.5% and 5.5%, is simple and data-based but may not reflect future trends or short-term MRP changes.

or

Forward Looking Data

(+) forward looking measure, allows for timely

MRP fluctuations, intuitive

(-) model-dependency, data are difficult access

—> Currently forward looking MRPs for the MSCI

Europe are at 6.5% (based on own model)

• What is “the market”

• What is the riskfree rate

• Which period of time is measured

• How averages were formed, arithmetically or geometrically

—> Ranges are between 2% and 8%

ERP is only a difference !

Driven be the expected/required return for equity (stocks) and the riskfree rate

• Inaccuracy of the statistical estimate

• foecast of the future beta

• mean reversion of beta

• Adjustment depends on the quality of the regression

• The larger the standard error of the regression (ie the worse the quality of the regression), the stronger the adaptation of the beta against the market average = 1