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A New Model For Estimating Risk Premiums (Along With Some Evidence Of Their Decline)

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  • Laurence Booth

Abstract

This article uses the Gordon growth model with a novel method for forecasting dividend growth rates to estimate the equity cost and associated risk premium for a sample of Canadian telecommunications companies. The results suggest that the Telco risk premium has declined significantly since the early 1980s. Moreover, this decline is accentuated when measured over long Canada yields, rather than over similarly taxed, longterm preferred yields. The findings of this study also suggest that the inverse relationship between utility risk premium and market interest rates reported by studies of U.S. utilities does not hold in Canada. If anything, the Telco risk premium has tended to vary directly with the level of market interest rates, with risk premium falling along with the general decline in rates. The main reason for these results seems to be the significant increase in interest rate risk, which has caused the long Canada yield to be a very poor proxy for the longterm, riskfree rate. One practical implication of this finding is that companies that estimate equity costs as a premium over longterm government bond yields are probably seriously overestimating the cost.

Suggested Citation

  • Laurence Booth, 1998. "A New Model For Estimating Risk Premiums (Along With Some Evidence Of Their Decline)," Journal of Applied Corporate Finance, Morgan Stanley, vol. 11(1), pages 109-120, March.
    • Handle: RePEc:bla:jacrfn:v:11:y:1998:i:1:p:109-120
    DOI: 10.1111/j.1745-6622.1998.tb00082.x
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    Cited by:

    1. Fredj Jawadi & Georges Prat, 2017. "Equity prices and fundamentals: a DDM–APT mixed approach," Review of Quantitative Finance and Accounting, Springer, vol. 49(3), pages 661-695, October.

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