Build-up Models

1. b

2. d

3. b

4. b

True or False Questions

5. False. fhhotson's risk premium series are based on 1-, 5-, and 20-year maturities, so using a 10-year maturity for the risk-free rate does not have a matching risk premium.

6. False

7. True

8. True

Fill-in-the-Blank Questions

10 11 12 13 14

Equity risk premium Historic Lower; equal Risk-free; risk Risk premium Does Exercises

15. The formula for the arithmetic mean equily risk premium is:

Excess Returns on the

x = arithmetic average

Ri = (he excess return for period in ~ number of observation periods

V'e can tabulate the data as follows:

Returns on U.S. rear Returns on the Market Treasury Obligations

0.03		0.40
0.06		0.09
0.02		0.18
0.05		-0.35
0.06		-0.04
urn = 0.28/5 =	= 5.6% or =	= 6%

1 0.43

.15 .20 .30 .02

Short-term arithmetic mean equity risk premium = 0. 16. The formula for the aeometric mean is:

i

G =

-i

ye:

G = Geometric average

Ri = Return for the itli period (the returns measured for each period are actually

excess returns, that is, tlie difference between the equity market return and tlie

Treasury-obligation income return for the n ~ Number of observation periods

We can tabulate the results as follows:

on

Year Returns on the Market

1 0.43

2 0.15

3 0.20

4 -0.30

5 0.02

Short-term geometric mean equity 1.7. Risk-free rate

+ Equity risk premium

+ Size premium

+ Company risk premium

Returns on T	J.S.	1 + Excess Retu
Treasury Obli^	ations	tlie Market
0.03		1.40
0.06		1.09
0.02		1.18
0.05		0.65
0.06		0.96

premium

Vl-1236 -1 = 1.02 -1 = 0.02 or 2%

6% 7% 8% 2%

ABC cost of equity capital

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