Question #8
Reading: Reading 17 Cost of Capital - Advanced Topics
PDF File: Reading 17 Cost of Capital - Advanced Topics.pdf
Page: 3
Status: Unattempted
Correct Answer: A
Question
Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will:
Answer Choices:
A. both increase the size of the risk premium
B. both decrease the size of the risk premium
C. have offsetting effects
Explanation
Switching from a geometric mean to an arithmetic mean will increase the mean equity
return. All else being equal, that will increase the estimated risk premium. When the yield
curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity
risk premium estimate will be larger when short-term bond rates are used.