Hello, when anyone calculate discount rate (cost of equity) using CAPM he has to find risk free rate, risk premium and size premium. We have different sources of them. How to reconcile all of them? As I understand risk free rate and risk premium are strongly correlated with each other, i.e. if you use 20-y treasures for risk free you have to use risk premium based on 20-y treasures. But size premium is independent of them. Am I right?

Question

Hello, when anyone calculate discount rate (cost of equity) using CAPM he has to find risk free rate, risk premium and size premium. We have different sources of them. How to reconcile all of them? As I understand  risk free rate and risk premium are strongly correlated with each other, i.e. if you use 20-y treasures for risk free you have to use risk premium based on 20-y treasures. But size premium is independent of them. Am I right?

anonymous · Answer

What do you mean by size premium? All of your numbers should be related to each other.

anonymous · Answer

I mean additional premium over CAPM for small size of the company (for small capitalization). Imagine the situation: I have 10-y tr yield to maturity as a risk free rate and risk premium based on that risk free rate. And on the other hand I have size premium over CAPM data which was calculated using 20-y tr yield to maturity as a risk free rate. Can I put these figures together correctly? Or I have to use 20-y tr yield to maturity as a risk free rate and corresponding risk premium?

anonymous · Answer

U mean country risk premium? If it's a small cap, is it a publicly listed one?

anonymous · Answer

The risk free rate is the rate on an investment that theoretically is risk free.  easy right.  The risk premium (also known as the equity risk premium) represents the return of a stock or stock market over and above the risk free return and needs to factor in the country risk, currency risk, etc. So, if the return of the investment is 15% and the risk free return is 8%, the risk premium is the difference. There is some debate over whether the size of a company needs to be factored in with a size premium to the CAPM equation but it's not generally used with CAPM.

anonymous · Answer

size premiums are widely used in practice, esspecially for closely held companies.Ibbotson provides a good research on them. And  how correctly incorporate them in calculations, this is an open question for me.

anonymous · Answer

@ apm  In CAPM model if you say its a small size company so it would be having higher beta's as compared with the mature growth companies so in your computation of  your cost of equity  ie risk free rate+beta * equity risk premium ...your have already considered the market risk to the small firm as measure of risk with higher beta ..now if you are charging more premium on the top of it again additional premium for what ??