Question

What would the stock price be if the companies risk premium increase to 7.00% (currently 5.10%)?

Answer 1

The relationship is inverse, i.e. higher the equity risk premium, lower the stock prices.

There are 2 ways to understand this -

The first one is simpler and more common-sensical. Higher risk premium means company is into a more risky business. In the long term, it has more chances of failing, and hence the stock prices are lower.

The second reason is supported by finance. We determine stock prices by discounting the Free Cash Flows to Equity (EAT) using the rate of discounting as the cost of equity

(k_{​​​​​​e}​​​).

As the risk premium is more,k_{​​​​​​e}​​​​​ is positive part of denominator,so, market prices are falls.