Hey guys,

Im confused by the following answer from EOCQ - Corporate Finance, Cost of Equity - Advanced Topics:

“The required return reflects the magnitude of the historical ERP,

which is generally higher when based on a short-term interest rate (as a result of

the normal upward-sloping yield curve), and the current value of the rate being

used to represent the risk-free rate. The short-term rate is currently higher than

the long-term rate, which will also increase the required return estimate. Th

short-term interest rate, however, overstates the long-term expected inflatio

rate. Using the short-term interest rate, estimates of the long-term required re

turn on equity will be biased upward.”

In this case, what is the relationship between the short-term interest rate and the long-term expected inflation? How does the use of short-term interest rate affects the estimate of long-term required return on equity?

Also, with a downward-sloping yield curve, the requiret rate of return is higher because of this equation?

re = rf + ERP, and, in this case we are increasing the risk-free rate, is that why required return increases? But at the same time, isn’t the ERP decreasing? I’m confused here…

I would appreciate if anyone can solve this doubt, exams are close and I’m worried I still have basic doubts.

Thank you so much!