Question

In estimating market returns and risk free rates to be used in Cost of Capital calculations, what are some of the issues with both (1) historical rates and (2) projected returns?

Answer 1

HI

IN CAPM formula:

cost of equity = risk free rate +beta*(market return - risk free rate)

Below are the issues that can be found with historical rates:

1) Historical rates are from past period, but investor needs return for future periods and it cant be assumed that past period return will be same as future period return.

2) Some businesses are cyclic and therefore future returns can be totally opposite of past period return.

3) May be some economy or businesses were in high growth stage, but now they got matured or in declining phase so it would be wrong to assume historical rates and take that as calculation for cost of capital calculations.

Below can be the issues with projected returns:

1) Projected returns are just an estimate and user can be wrong in assuming that.

2) Projected returns can be influenced by user bias.

3) Investors may not be knowing future business prospectus or investments by economy which is important in estimating projected returns.

4) Future returns depend on political conditions which can change but investor may not aware of that.

Thanks