Suppose that over the last 25 years, company DEF has averaged a return of 7.5%. Over the same period, the Treasury bond rate has averaged 1.5%. The current estimate of the Treasury bond rate is 4%. Using the historical approach, what is the estimate of DEF's expected return?
Equity premium refers to the difference between average return on equity investment and average return on fixed income investments such as bonds. In the U.S., equity premium is between 3 percent and 7 percent. Some economists argue that this premium is too large and term it the equity premium puzzle.
Answer and Explanation:
The expected return of DEF is 10%.
We can use the following formula to estimate the expected return:
- expected return = risk free rate + risk premium
Risk premium is the expected return on an asset, net of the risk free rate, which is usually approximated by treasury bond yield. Based on past data, the treasury bond yield is 1.5%, and the DEF's return is 7,5%, which implies a risk premium = 7.5% - 1.5% = 6%.
Risk premium could be considered as constant over time, provided that the risk characteristics of the firm remains the same. Given new treasury bond yield of 4%, the expected return on DEF's is:
- 4% + 6% = 10%.
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 26