Page 71 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Fundamentals of Project Management

Notes β = Beta of the equity of company
E
E(R ) = Expected return on the market portfolio
M
The SML is regarded by many as a fairly rigorous and objective approach to determining the
required return on equity. This approach, however, is based on the assumption that investors
eliminate unsystematic risk by efficient diversification and hence require compensation only
for systematic risk which is reflected in beta. Market imperfections may impede efficient
diversification by investors, exposing them to unsystematic risk. When this occurs, investors
will require compensation for unsystematic risk, a factor which is not found in the security
market line relationship. Another shortcoming of the SML relates to the instability of the betas
of individual securities. Studies have shown that individual securities have unstable betas. This
makes the use of a historical beta as a proxy for the future beta somewhat questionable.
Notwithstanding these shortcomings, the SML approach is a useful approach for estimating the
required rate of return of equity stocks.

Bond Yield Plus Risk Premium Approach

Analysts who do not have faith in the SML approach often resort to a subjective procedure to
estimate the cost of equity. They add a judgmental risk premium to the observed yield on the
long term bonds of the firm to get the cost of equity:
Cost of equity = Yield on long-term bonds + Risk premium

The logic of this approach is fairly simple. Firms that have risky and consequently high cost debt
will also have risky and consequently high cost equity. So it makes sense to base the cost of
equity on a readily observable cost of debt.

The problem with this approach is how to determine the risk premium. Should it be 2 percent,
4 percent, or n percent? There seems to be no objective way of determining it. Most analysts look
at the operating and financial risks of the business and arrive at a subjectively determined risk
premium that normally ranges between 2 percent and 6 percent. While this approach may not
produce a precise cost of equity, it will give a reasonable ballpark estimate.

Earnings-Price Ratio Approach

According to this approach, the cost of equity is equal to:
E /P
l 0
Where
E = expected earnings per share for the next year
l
P = current market price per share
0
E may be estimated as: (Current earnings per share) × (1 + Growth rate of earnings per share).
l
This approach provides an accurate measure of the rate of return required by equity investors in
the following two cases:
1. When the earnings per share are expected to remain constant and the dividend payout
ratio is 100 percent.
2. When retained earnings are expected to earn a rate of return equal to the rate of return
required by equity investors.
The first case is rarely encountered in real life and the second case is also somewhat unrealistic.
Hence, the earnings-price ratio should not be used indiscriminately as the measure of the cost of
equity capital.

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