The Equity Risk Premium (ERP) is a key input used to calculate the cost of capital within the context of the Capital Asset Pricing Model (CAPM) (and other models).1 The ERP is used as a building block when estimating the cost of capital (i.e. “discount rate”, “expected return”, “required return”), and is an essential ingredient in any business valuation, project evaluation, and the overall pricing of risk.
Duff & Phelps regularly reviews fluctuations in global economic and financial conditions that warrant periodic reassessments of ERP. Based upon current market conditions, Duff & Phelps is decreasing its U.S. ERP recommendation to 5.5% when developing discount rates as of January 15, 2012 and thereafter, until further guidance is issued. Duff & Phelps reviews its ERP assessment on a monthly basis. We will continue to use 5.5% until such time evidence indicates equity risk in financial markets has materially changed.
In developing our ERP recommendation, we incorporated a “normalized” 20-year yield on U.S. government bonds of 4.0%, implying a 9.5% (5.5% + 4.0%) “base” cost of equity capital estimate in the U.S. as of mid-January 2012. Were we to use the spot yield-to-maturity of 2.6% as of mid-January, 20122, we would arrive at an overall discount rate inappropriately low vis-à-vis the risks currently facing investors.3
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1 The cost of capital is the expected rate of return required to attract funds to a particular investment.
2 The 20-year Treasury yield published as of January 15, 2012 is 2.59% (dated January 13). Source: Board of Governors of the Federal Reserve System website at: http://www.federalreserve.gov/releases/h15/data.htm.
3 To learn more about the equity risk premium, the risk-free rate, and other cost of capital related issues, visit www.duffandphelps.com/costofcapital
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