Question

Briefly explain the following methods; the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method

Answer 1

The CAPM method : this method is used to calculate the required return of a security. This method assumes that an investor is only compensated for the systematic risk of the security. The formula for the calculation of the required return determines the relationship between the required return and the systematic risk of a security. The formula is :

Re = Rf + beta (Rm - Rf

DCF method; this is a valuation method, used to calculate the present value of the expected cash flows into the future discounted at the discount rate which is the required rate of return/ WACC. The value of a security can be computed as :

DCF = CF1/(1 +r)^1 + CF2/(1+R)^2 + CF3/(1+R)^3 +.... CFN/(1+R)^N

The bond yield risk premium approach : This method calculates the required rate of return on equity, where were we take the yield to maturity in the long term debt  and we add the equity risk premium to it.

Re = Rd + risk premium.