Explain how you estimate the risk-free rate, market risk premium (in CAPM), and dividend growth rates...

Explain how you estimate the risk-free rate, market risk premium (in CAPM), and dividend growth rates (in stock valuation model).

Expert Solution

CAPM MODEL

Equation

Expected return = rf + Beta ( Rm - rf )

rf = risk free rate

Rm = Return on market

So inorder to findout the expected return in CAPM we should find out risk free rate and market risk premium

Risk free rate - To calculate the real risk free rate deduct the current inflation rate from the yield of the Treasury bond that matches your investment duration. for example, the 10-year Treasury bond yields 3%, investors would consider 3% to be the risk free rate of return.

Market risk premium- The market risk premium can be calculated by subtracting the risk free rate from the expected equity market return.

= (riskfree rate - return on market )

Rm or return on market can be findout by looking in to the particular index of the stock market.

Dividend growth rate - When we valuing a stock it is important to findout the dividend growth rate. How it can be obtained?

By dividing the dividend at the end of the period by the beginning dividend we can arrive at dividend growth rate. If we are taking a long period then we should adjust the year by doing Nth root of the particular amount. Here N represent the number of year. Then we will get a value. Deduct 1 from that particular value and multiple with 100 to get divident growth rate in percentage.

These are the steps for calculating risk free rate, market risk premium and dividend growth rate.

ThankYou...

jeff jeffy answered 2 years ago

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