FINA 2330

Ch. 13 Supplementary Notes

Agenda
◼ Required Return

◼ Equity Risk Premium

◼ The Required Return on Equity – CAPM

Required Return (1/3)
◼ Required Rate of Return (or simply, Required Return)
is the minimum level of expected return that an investor
requires in order to invest in the asset over a specified
time period, given the asset’s riskiness.
Required Return (2/3)
◼ Different investors may have different required returns
due to the difference in investment profiles, available
information, available opportunities, etc.
◼ Nevertheless, generic estimate of required return for an
asset can be obtained from models (e.g. Capital Asset
Pricing Model) using observed marketplace data and
variables (e.g. asset returns) rather than based on the
return requirements of individual investors. As the market
variables contain the information about the investors’
asset risk perception and their level of risk aversion, fair
compensation for risk to the investors are determined.
Hence, the estimate of required return for the asset
represents the investors’ requirements in general.
Required Return (3/3)
◼ For common stock and debt, in the perspective of issuer,
the required rates of return are known as cost of equity
and cost of debt respectively.
‒ To raise new capital, the issuer would have to offer
expected return for the security which is competitive with
the expected returns offered by other securities with
similar risk.
‒ The required return on a security is the issuer’s marginal
cost for raising additional capital of the same type.
◼ The estimates of required returns are important in the
use of present value models as the models require
applying appropriate discount rates to discount the
expected future cash flows to present values.
Equity Risk Premium (1/4)
◼ Equity risk premium is the incremental return
(premium) that investors require for holding equities
rather than the risk- free asset. Thus, it is the difference
between the required return on equities (typically
represented by an equity market index) and the
expected risk-free rate of return.
Equity Risk Premium (2/4)
◼ In general, for an average systematic risk equity security,
Required return on = Current expected + 𝛽 × Equity risk premium
equity security i risk- free return 𝑖

Required return on the equity security is adjusted by the

security’s specific equity risk premium for systematic risk
which is measured as a coefficient of beta (𝛽𝑖 ).
− If 𝛽𝑖 = 1, systematic risk of the security is average.
− If 𝛽𝑖 < 1, systematic risk of the security is lower than average.
− If 𝛽𝑖 > 1, systematic risk of the security is higher than average.
Equity Risk Premium (3/4)
◼ Estimate of equity risk premium for the whole equity
market of a country can be calculated as the mean value
of the historical differences between the returns of a
broad-based equity market index and the returns of
government debts over a sample period.
Equity Risk Premium (4/4)
◼ The historical estimate is determined based on the
selection of following elements:
− (a) the index to represent equity market returns
− (b) the sample period
− (c) the type of mean calculated
− (d) the proxy for risk-free return
The Required Return on Equity – CAPM (1/6)
◼ As the estimates of equity risk premium are available,
the required return on the equity of a particular issuer
can be estimated using the Capital Asset Pricing Model
(CAPM).
◼ In a portfolio of securities, the idiosyncratic (specific) risk
of individual securities tend to offset each other leaving
largely the market (systematic) risk. The Capital Asset
Pricing Model (CAPM) is a model for required return
which states the relationship that should hold in
equilibrium if the assumptions of the model are met
which mainly include,
− investors are risk averse.
− investors make investment decisions based on the mean
return and variance of returns of their total portfolio.
The Required Return on Equity – CAPM (2/6)
◼ The expression for the CAPM used in practice is as
follows:
Required return on = Current expected + 𝛽 × Equity risk premium
equity security i risk- free return 𝑖

◼ Systematic risk is the risk inherent to the entire market

that cannot be eliminated by diversification. The CAPM
evaluates the risk of a security in terms of its contribution
to the systematic risk (measured as 𝛽𝑖 ) of the whole
portfolio.
The Required Return on Equity – CAPM (3/6)
◼ The equation for the CAPM is as follows:
E(Ri) = E(RF ) + βi × [E(RM) – E(RF )]
where, E(Ri) = Expected return on a security i
E(RF) = Expected risk-free rate (no default risk)
βi = Beta of security i (being the return sensitivity of
security i to changes in market return)
E(RM) = Expected market return
E(RM) – E(RF ) = Expected market risk premium
◼ Practical notes :
‒ The yield of default-free government debt instruments are
commonly taken as proxies for the risk-free rates.
‒ In practice, return of equity market index is taken to represent
E(RM). The estimated market risk premium is in fact an estimate
of the Equity Risk Premium (ERP). The security’s beta is
estimated relative to the equity market index.
The Required Return on Equity – CAPM (4/6)
◼ The asset’s beta measures its systematic risk (or market
risk) which is the sensitivity of its returns to the returns
on the “market portfolio” of risky assets.
◼ The beta of security 𝑖 is as follows:
𝜎𝑖𝑚
𝛽𝑖 =
𝜎𝑚 2
where 𝜎𝑖𝑚 is the covariance of the returns of security 𝑖
with the returns of the market portfolio, and 𝜎𝑚 2 is the
variance of the returns of the market portfolio.
◼ In practice for equity valuation, the market portfolio is
usually represented by a broad value-weighted equity
market index.
The Required Return on Equity – CAPM (5/6)
◼ Example: (Source : CFA Curriculum)
Exxon Mobil Corporation, BP p.l.c., and Total S.A. are three
“super major” integrated oil and gas companies
headquartered, respectively, in the United States, the United
Kingdom, and France. An analyst estimates that the equity
risk premium in the United States, the United Kingdom, and
the Eurozone are, respectively, 4.5 percent, 4.1 percent, and
4.0 percent. Other information is summarized as followings:

Using the CAPM to calculate the required return on equity.

The Required Return on Equity – CAPM (6/6)
◼ Example (Continued):
Solution :
According to the CAPM, the required return on equity
for Exxon Mobil : 3.20% + 0.77 × 4.50% = 6.67%
for BP p.l.c. : 3.56% + 1.99 × 4.10% = 11.72%
for Total S.A.. : 2.46% + 1.53 × 4.0% = 8.58%