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We need the market risk premium to arrive at the cost of equity when using the CAPM model. Finance professionals estimate market risk premium by looking at historical returns. Is that appropriate? Is that accurate? Does it serve the purpose?
We examine the appropriateness or inappropriateness of estimating market risk premium by looking at historical returns. by examining this question today: “What are the issues you face in estimating a market risk premium?”
You need the risk free rate to arrive at the WACC or discount rate at which you will discount your cash flows in a DCF valuation model. How will you pick your discount rate?
We address on this page the question: “How would you estimate risk free rate when valuing an international firm?”
The CAPM, Fama-French, APM and multi-factor models methods of estimating the cost of equity are built on assumptions. What are the assumptions? Do these assumptions reflect real-life situations? We examine these models to evaluate if they systematically over estimate or under estimate the cost of equity.
We examine the question: “Do the CAPM, Fama-French, APM and multi-factor models methods of estimating the cost of equity generally overestimate or underestimate the equity cost? Why?”
You need the value of debt and equity to arrive at WACC. This ratio of debt and equity gives you the weights of debt and equity to arrive at WACC. In many cases, the company may have a temporary debt and equity structure. An example is a leveraged buy-out – where excessive amounts of debt is loaded for the LBO transaction. This level of debt is not sustainable and so the company pares down the debt quickly. How do you estimate the “normal” level of debt the company will work towards so you can arrive at the appropriate discount rate? The target debt ratio is the debt ratio that you assume the firms will move towards over time from the current mix of debt and equity.
We address this question today: “What is the target debt ratio of a firm? How do you arrive at it?”