Eugene F. Brigham

Estimating the Market Risk Premium

One of the basic approaches to estimating the cost of common equity capital is the risk premium method, sometimes called the yield spread method. Analysts recognize that because investors are risk averters, the required rate of return increases as the riskiness of financial assets increases. Therefore, if investors have the opportunity to buy default-free U.S. Treasury bonds with a yield of 8 1/2 percent, they would require higher rates of return on corporate bonds and still higher returns on common stocks.1 The question is: How much higher? If we knew the answer to that question, we could, at any given time, determine the cost of common equity simply by adding the risk premium to the current yield on Treasury bonds.