FINC2011 Lec 9 Company Cost of Capital Flashcards
One method to estimate cost of equity is to IMPLY FROM CURRENT PRICES. What are the problems with this method? (4)
- Assumes market has correctly priced security in first place.
- Current price P0 is constantly moving.
- Assumes constant growth rate.
- Dependent on quality of dividend and growth forecasts.
Another method to estimate cost of equity is to use CAPM. What are the problems with this method?
- Requires estimate of current risk free rate
- Requires estimate of beta
- Requires estimate of expected market risk premium
What are the problems with estimating beta? (2)
- Stocks change betas / risk through time.
* Beta estimates are from a limited number of obervations resulting in measurement error.
What are 3 methods for estimating expected market risk premium?
- Use historical ave returns of stock market.
- Imply from share prices and analysts forecasts (for a large smaple of securities).
- Regression analysis to estimate relationship between stock market volatility and stock market returns.
What are the problems with using historical ave returns of stock market?
- Assumes historical returns equal to future returns expected by market participants.
- GFC? no logical sense to account for it in perpetuity. However, also untrue to assume there will never be a financial crisis in the future.
- Assumes MRP constant over time.
What are the problems with impling from share prices and analysts forecasts (for a large sample of securities)?
- Filters out mispricings but assumes whole market is not mispriced.
- Dependent on quality of analysts forecasts.
What are the problems with using regression analysis to estaimte the relationship between stock market volatility and stock market returns?
rm - rf = a + bQ^2(t)
where Q^2(t) = stock return volatility for period t.
*Assumes market is a well-diversified portfolio therefore only exposed to market risk.
