The

Estimating the cost of common equity is challenging due to the uncertain nature of the amount and timing of future cash flows.

where R

For example, firm A has a β

There are several ways to estimate the equity risk premium.

- The
**historical equity risk premium approach**examines the historical data of realized returns from a country's market portfolio and uses the average rate for both the market portfolio and risk-free assets. One study, cited in the textbook, found that the annualized U.S. equity risk premium relative to U.S. Treasury bills was 5.3% (geometric mean). However, there are some limitations to this approach. For example, the level of risk of the stock index and risk aversion of investors may change over time. - The
**dividend discount model approach**(or**implied risk premium approach**) analyzes how the market prices an index using the Gordon growth model:_{e}is the required rate of return on the market, D_{1}is the dividends expected next period on the index, P_{0}is the current market value of the equity market index, and g is the expected growth rate of the dividends. - The
**survey approach**is a direct one: ask a panel of financial experts for their estimates and take the mean response.

where D

P

Because the cost of capital of riskier cash flows is higher than that of less risky cash flows:

This is a subjective, ad hoc procedure: bond yield is the interest rate on the firm's long-term debt, and the risk premium is a judgmental estimate (usually 3-5%). For example, suppose that ABC, Inc.'s interest rate on long-term debt is 10%. Assume the risk premium is 5%. ABC's cost of retained earnings is 10% + 5% = 15%.

tomalot: This is hard |

fobucina: Everything is a matter of practice.. Just put in the work and you'll get it |

Inaganti6: This isn't rocket science but it's mind numbing to remember if you don't practice |

guest: this LOS is small here compared to the whole picture, I advise everyone to read it in the book. |

khalifa92: the risk premium(bond yield approach) is not to be confused with the equity risk premium (CAPM):1- equity risk premium is the difference between the cost of equity and the risk-free rate of interest. 2- risk premium is the difference between the cost of equity and the company's cost of debt. |

urbanmonk: Helpful clarification khalifa92, many thanks |