Chartered Financial Analyst Level 2
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55 An analyst gathers the following information about a public company:
- Growth rate: 3%
- Forward dividend (D₁):
$5 - Risk premium over cost of debt: 7%
- Cost of debt: 6%
- Risk-free rate: 2%
- Estimated beta: 1.1
Based only on the data in the table, the required ROE can be calculated using which of the following?
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A
DDM
B
CAPM
C
Bond yield plus risk premium approach
Explanation:
Explanation
The correct answer is C. Bond yield plus risk premium approach.
Analysis:
Looking at the provided data:
- Cost of debt: 6%
- Risk premium over cost of debt: 7%
- Risk-free rate: 2%
- Estimated beta: 1.1
- Growth rate: 3%
- Forward dividend (D₁):
$5
Why Bond Yield Plus Risk Premium Approach:
The bond yield plus risk premium approach calculates the required return on equity as:
Required ROE = Cost of debt + Risk premium over cost of debt
Using the given data:
- Cost of debt = 6%
- Risk premium over cost of debt = 7%
- Required ROE = 6% + 7% = 13%
Why Not Other Options:
A. DDM (Dividend Discount Model): While we have dividend data (D₁ = $5) and growth rate (3%), we would need the current stock price to calculate the required ROE using DDM. Without the stock price, we cannot solve for the required return.
B. CAPM (Capital Asset Pricing Model): We have the risk-free rate (2%), beta (1.1), but we're missing the market risk premium. The "risk premium over cost of debt" (7%) is different from the market risk premium needed for CAPM.
Conclusion:
The bond yield plus risk premium approach is the only method that can be directly calculated with the provided data, using the cost of debt and the specific risk premium over cost of debt that's explicitly given.
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