Question

In the current interest rate environment using a required return estimate based on the short-term government bond rate and a historical equity risk premium defined in terms of a short-term government bond rate would be expected to

a) bias long-term required return on equity estimates upwards

b) biaslong-term required return on equity estimates downwards

c) have no effect on long-term required return on equity estimates

Answer 1

Answer:- Option (a):- bias long-term required return on equity estimates upwards

Explanation:- The required return reflects the magnitude of the historical equity risk premium, 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. The short-term interest rate, however, overstates the long-term expected inflation rate. Using the short-term interest rate, estimates of the long-term required return on equity will be biased upwards.