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Bond Yield and Risk Premium Approach
We can estimate the value of a company's equity by adding its risk premium to the yield to maturity on the company's longterm debt.
Learning Objective

Describe the process for the bond yield plus risk premium approach
Key Points

The BYPRP approach applies to a company's publicly traded equity.

The yield to maturity is the discount rate at which the sum of all future cash flows from a bond are equal to its price.

The equity risk premium is the return that stocks are expected to receive in excess of the riskfree interest rate.

The BYPRP approach does not produce as accurate an estimate as the capital asset pricing model or discounted cash flow analysis.
Terms

coupon payment
A periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures.

dividend yield
A company's total annual dividend payment per share, divided by its price per share.

principal payment
The payment made upon maturity of a bond
Examples

A company's longterm debt has a yield to maturity of 6%. The risk premium on its equity is 4%. Thus, the required return on the company's equity is 10%.
Full Text
Bond Yield Plus Risk Premium Approach
The bond yield plus risk premium (BYPRP) approach is another method we can use to determine the value of an asset, specifically, a company's publicly traded equity. BYPRP allows us to estimate the required return on an equity by adding the equity's risk premium to the yield to maturity on company's longterm debt.
Bond Yield vs. Risk Premium
Simply put, the yield on a bond is the rate of return received from the investment. In the BYPRP approach, we use a bond's yield to maturity, which is the discount rate at which the sum of all future cash flows from the bond (coupon payments and principal payments) are equal to the price of the bond. This is also referred to as the internal rate of return (IRR).
The equity risk premium is essentially the return that stocks are expected to receive in excess of the riskfree interest rate. The normal historical equity risk premium for all equities has been just over 6%. In general, an equity's risk premium will be between 5% and 7%. Common methods for estimating the equity risk premium include:
 The Fed Model (forward operating earnings yield [earnings per share divided by share price] minus the 10year U.S. Treasury Bond yield)
 The dividend yield plus projected earnings growth, minus the 10year Treasury yield
 The historical stock returns minus the 10year Treasury yield
Estimating the value of an equity using the bond yield plus risk premium approach has its drawbacks. We can only utilize the BYPRP approach if the entity has publicly traded debt, and it does not produce as accurate an estimate as the capital asset pricing model or discounted cash flow analysis.
Moreover, equity risk premium estimates can be highly inaccurate, while also varying wildly depending on which model is used. It can be very difficult to get an accurate estimate of the risk premium on an equity, having a duration of roughly 50 years, using a riskfree rate of such short duration as a 10year Treasury bond.
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Key Term Reference
 Assets
 Appears in this related concepts: What is a Financial Statement?, Define the Marketing Objectives, and Secured vs Unsecured Funding
 Interest
 Appears in this related concepts: Interest Compounded Continuously, Debt Utilization Ratios, and Tax Considerations
 Risk free rate
 Appears in this related concepts: Risk Adjusting the Discount Rate, Expected Risk and Risk Premium, and The Cost of Debt
 Stock
 Appears in this related concepts: Ownership Nature of Stock, Agency, and Advantages of Private Financing
 Treasury bond
 Appears in this related concepts: The Yield Curve, Using the Yield Curve to Estimate Interest Rates in the Future, and The Nature of Bonds
 Yield to maturity
 Appears in this related concepts: Reinvestment Risk, Duration, and Other Features
 analysis
 Appears in this related concepts: Interpreting Ratios and Other Sources of Company Information, Scenario Analysis, and The Importance of Rehearsing
 asset
 Appears in this related concepts: Special Considerations for Acquisition and Depletion of Natural Resources, Introduction to the Balance Sheet, and Role of Finance in an Organization
 bond
 Appears in this related concepts: Reporting Current Liabilities, Managers, Shareholders, and Bondholders, and Comparing Common Stock, Preferred Stock, and Debt
 capital
 Appears in this related concepts: Types of Businesses, Types of Financial Markets, and Defining Capital
 cash flow
 Appears in this related concepts: Cash Flow, Interpreting the NPV, and Interpreting Overall Cash Flow
 debt
 Appears in this related concepts: The State of Global Business, Financing Life Cycle of the Firm, and Collection from Delinquent Payables
 discount
 Appears in this related concepts: The Discount Rate, Par Value at Maturity, and Present Value, Multiple Flows
 discount rate
 Appears in this related concepts: Factors Affecting the Price of a Bond, Calculating the NPV, and NPV Profiles
 discounted cash flow
 Appears in this related concepts: Valuing the Target and Setting the Price, Valuing the Corporation, and Ranking Investment Proposals
 dividend
 Appears in this related concepts: Residual Dividend Model, The Role of the Nonprofit, and Dividing Polynomials
 duration
 Appears in this related concepts: Disadvantages of the IRR Method, Time to Maturity, and Differences and Commonalities Between Price and Reinvestment Risks
 equity
 Appears in this related concepts: Key Considerations for the Statement of Cash Flows, Civil Law and Criminal Law, and Trading off Equity and Efficiency
 interest rate
 Appears in this related concepts: Wealth, Why is it Important?, and The Financial Account
 investment
 Appears in this related concepts: The Upper Class, Functions of Corporate Finance, and Agencies
 maturity
 Appears in this related concepts: Redeeming at Maturity, Amortized Cost Method, and Maturity
 premium
 Appears in this related concepts: The Term Structure, The Freemium Model, and Health Insurance
 principal
 Appears in this related concepts: Types of Bonds, Defining Agency Conflicts, and Maximizing Shareholder and Market Value
 required return
 Appears in this related concepts: Calculating the Yield to Maturity using the Bond Price, Differences Between Required Return and the Cost of Capital, and The Capital Asset Pricing Model
 return
 Appears in this related concepts: Dollar Returns, Finance, Economics, and Accounting: Differences and Commonalities, and Disadvantages of the Payback Method
 risk
 Appears in this related concepts: The ExportImport Bank of the United States, Portfolio Risk, and Defining Risks in Capital Budgeting
 risk premium
 Appears in this related concepts: Understanding Future Stock Value, Measuring and Managing Risk, and The Value of Diversification
 yield
 Appears in this related concepts: Bonds Payable and Interest Expense, Stock Warrants, and Calculating the Yield of an Annuity
Sources
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Source: Boundless. “Bond Yield and Risk Premium Approach.” Boundless Finance. Boundless, 14 Nov. 2014. Retrieved 23 Apr. 2015 from https://www.boundless.com/finance/textbooks/boundlessfinancetextbook/introductiontothecostofcapital10/approachestocalculatingthecostofcapital89/bondyieldandriskpremiumapproach3838734/