- CFA Exams
- CFA Level I Exam
- Study Session 10. Equity Valuation (2)
- Reading 27. Discounted Dividend Valuation
- Subject 3. The Gordon growth model

###
**CFA Practice Question**

Which of the following statements is (are) true with respect to the calculation of risk premium when computing the cost of equity?

II. Historical risk premium would be more valid is the arithmetic average of returns was used.

III. According to the Gordon growth model, the risk premium would increase as long term government bond prices increase, holding everything else constant.

IV. The cost of equity may also be estimated by adding to the risk-free rate, the YTM that exists on the issuer's outstanding bonds.

I. If the geometric average of historical returns is used, as opposed to the arithmetic average, the risk premium will be smaller.

II. Historical risk premium would be more valid is the arithmetic average of returns was used.

III. According to the Gordon growth model, the risk premium would increase as long term government bond prices increase, holding everything else constant.

IV. The cost of equity may also be estimated by adding to the risk-free rate, the YTM that exists on the issuer's outstanding bonds.

A. III and IV

B. I and III

C. I, II, III, and IV

**Explanation:**II is incorrect because historical risk premium would be more valid if the geometric average of returns was used. Arithmetic averages give us the best indication of what might be the next single period's return; however, geometric return illustrates what the average return might be over multiple periods.

III is true because as the long term government price increases, its yield (which would be the risk-free rate) would decrease, causing the premium to increase.

IV is incorrect because the risk-free rate is already built into the YTM. Instead, to estimate the cost of equity, a premium equal to the issuer's equity risk relative to its debt, is added to the YTM.

###
**User Contributed Comments**
2

User |
Comment |
---|---|

DariSH |
Not sure about III. If Rf decreases, wouldn't in also decrease the required rate of return? Besides, in terms of equity risk premiums, who says that the spread between Rf and the stock market would widen? |

DariSH |
Oh, I get it, forget the earlier note :) |