Mock test 1 has this question Hughes is initially interested in determining the required return on equity for the rail company of interest. He considers several methods that can be utilized for this purpose and makes the following notes:
The capital asset pricing model (CAPM) captures company specific and market risk.
The Fama–French model includes factors that measure size and value.
The bond yield plus risk premium method incorporates the yield to maturity of a company’s debt.
Which of Hughes’ notes regarding the various methods of estimating the required return on equity is least accurate?
the correct answer is 1- that capm does not have a company specific risk.
on the cfa institute book 5 page 588 question 10 asks if this statement is correct “If the CAPM method is used to estimate the discount rate with a beta estimate based on public companies with operations and revenues similar to Thunder, then a small stock premium should be added to the estimate.” apparently this statement is correct. the explanation given is “If the CAPM is used with public companies with similar operations and similar revenue size, as stated, then the calculation likely captures the small stock premium and should not be added to the estimate.” i am getting confused with these 2 statements. what is a small stock premium and is this the same thing as the company specific risk being asked in the mock exam? can someone please explain this?
Remember, these are premiums you receiving for investing in smaller-cap companies or a liquidity(or lack there of) premiums and also firm specific risk/premiums
1)CAPM risk premium for market. Rf +B(market risk) 2) FF risk premium for smaller caps (SMB) and value (HML) 3) PP adds a liquidity premium 4) Cohart adds a momentum premium
Company specific premium is not the same as a small-cap premium. It has to do with that particular firms risk that are different from other firms so you can add it add at the end under the build up method.
a small stock premium is the additional return over a risk free rate, demanded by an investor for investing in a small sized company. a standard capm doesn’t include small size premium. what 125mph meant was if you’re valuing a small cap stock, to gets its premium, you will take the rm on the small cap index and negate it from the risk free rate. doing this, captures your small stock premium or small cap premium.
Simply plug in CAPM formula RF + Beta (Market return-Risk Free) does it contain company specific risk? no then it is the only wrong statement both FFM and bond yield are correctly stated