Question

which of the following is not an element in the bond yield plus risk premium approach?

Select one:

a. The benchmark's bond's internal rate of return.

b. The current yield on U.S. Treasury Bonds.

c. The future cash flows from the benchmark bond.

d. The company's CAPM.

Answer 1

Bond Yield Plus Risk Premium Approach (BYPRP): This is one of the approaches to calculate cost / required rate of return of equity to the organisation. This is calculated by adding risk premium to the YTM (Yield to Maturity) of organisation’s long term debt. Two Key main points to understand here is Risk Premium and YTM of long term Debt. Risk premium is the additional return expected over the risk free rate of return for taking the risk. YTM is the rate at which if all the future cash flows of debt i.e., both coupon and principal repayments, are discounted is equal to price of the bond.

Rs = Rd + RP

Where,

· Rs is the required rate of return for an equity

· Rd is the cost of organisation’s long term debt

· RP is the risk premium required

Capital Asset Pricing Model(CAPM) is a completely different method to calculate the required rate of return taking sensitivity of risk of that asset into consideration. BYPRP approach has nothing to do with CAPM approach. Both are different methods to calculate required rate of return of equity.

Applying theory learned to the question asked:

Correct answer is D. The Company’s CAPM because CAPM is a completely different calculate the required rate of return. CAPM is not an element of BYPRP

Why not the other Options?

a. Benchmark bond’s internal rate of return is YTM (Rd) which is required in our formula above

b. Current yield on U.S. Treasury Bonds is necessary to calculate risk premium (RP)

c. Future cash flows from the benchmark bond are required to discount for finding out the yield (Rd)