Question #9

There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates. (Module 17.2, LOS 17.c) Sofie Johansen is a new financial analyst at Rikdom Investments. Johansen meets with her manager to discuss a possible investment in Helsevesen Health Care. Johansen's manager asks her to estimate the cost of common equity using the Fama-French five-factor model for Helsevesen as a first step in valuing Helsevesen. Johansen estimates Helsevesen's cost of equity by regressing Helsevesen's excess return on relevant risk factors using past 120-month returns. The resulting factor betas and risk premiums are shown in  Factor Betas and Risk Premiums. Factor Betas and Risk Premiums Factor Factor Beta Risk Premium Market (ERP) 1.40 3.5% Size (SMB) 0.85 1.8% Value (HML) 0.65 1.5% Profitability (RMW) 0.15 1.6% Investment (CMA) 0.60 2.1% Johansen decides to use the government 20-year benchmark interest rate of 3.4% as the risk-free rate. Johansen's manager also asks her to estimate Helsevesen's cost of equity using the bond yield plus risk premium (BYPRP) method. For this estimate, Johansen assumes a historical risk premium of 5.4% earned by equity investors over long-term corporate bond yields. Further, she calculates an estimated cost of debt of 4.9% using matrix valuation. Finally, Johansen is asked to estimate the ERP for the country of Yukon. Selected data is given in  Yukon Selected Data Yukon Selected Data Per Year Estimated earnings growth rate for public companies 5.00% Forecasted market P/E growth 1.20% Real GDP growth rate forecast 2.50% Estimated aggregate dividend yield 0.60% Current level of inflation 3.50% ST government yield 5.00% LT government yield 5.50% Growth in shares outstanding 1.35% Yukon's central bank, with a tight monetary policy, is expected to bring inflation down to 2.50% per year.