Question

Which of the following statements about cost-of-equity estimation is most correct?

A) The CAPM approach is always superior to the DCF approach.

B) The risk premium used in the debt-cost-plus-risk-premium approach is the same as the risk premium used in the CAPM approach.

C) Because the CAPM and DCF approaches use market data, they provide precise cost-of-equity estimates.

D) The debt-cost-plus-risk-premium approach can be used when the business does not have publicly traded equity.

E) All approaches always produce estimates that fall within a narrow range.

I know A, B & E are wrong. I'm between C & D. I think it's D because the word "precise" in C raises a red flag.

Answer 1

The correct answer is option D. The debt-cost-plus-risk-premium approach can be used when the business does not have publicly traded equity.

Cost of equity = Debt Cost + Risk Premium

You are right in eliminating the answer option C because it makes an extreme statement (the word 'precise'). For the same reason you can also eliminate option A because of the word 'always'.

Option B is incorrect because the risk premium in both the approaches are not the same.

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