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The "Bond Yield Plus 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

principal payment
The payment made upon maturity of a bond

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

coupon payment
A periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures.
Example
 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.
Key Term Reference
 Assets
 Appears in these related concepts: Defining the Financial Statement, Wealth, and Defining the Marketing Objectives
 Interest
 Appears in these related concepts: Your Areas of Interest, Interest Compounded Continuously, and Debt Utilization Ratios
 Stock
 Appears in these related concepts: Ownership Nature of Stock, Agency, and Advantages of Private Financing
 Treasury bond
 Appears in these related concepts: The Yield Curve, Using the Yield Curve to Estimate Interest Rates in the Future, and The Nature of Bonds
 Treasury bonds
 Appears in these related concepts: Financial Instruments and Answers to Chapter 2 Questions
 Yield to maturity
 Appears in these related concepts: Reinvestment Risk, Duration, and Other Features
 analysis
 Appears in these related concepts: The Impact of External and Internal Factors on Strategy, Interpreting Ratios and Other Sources of Company Information, and Features and Attributes of a Product
 asset
 Appears in these related concepts: Defining the Balance Sheet, Preparation of the Statement of Cash Flows: Direct Method, and LimitedLife Impairment
 bond
 Appears in these related concepts: Managers, Shareholders, and Bondholders, Preferred Stock, and Credit Ratings
 capital
 Appears in these related concepts: Issuing Stock, Inputs and Outputs of the Function, and Other Factors of Production
 cash flow
 Appears in these related concepts: Defining the Cash Flow Cycle, Calculating the NPV, and Interpreting the NPV
 debt
 Appears in these related concepts: DebttoEquity Ratio, LongTerm Debt, and Deficit Spending, the Public Debt, and Policy Making
 discount
 Appears in these related concepts: The Discount Rate, Par Value at Maturity, and Present Value, Multiple Flows
 discount rate
 Appears in these related concepts: Present Value of Payments, NPV Profiles, and The Federal Reserve and the Financial Crisis of 2008
 discounted cash flow
 Appears in these related concepts: Valuing the Target and Setting the Price, Valuing the Corporation, and Ranking Investment Proposals
 dividend
 Appears in these related concepts: The Role of the Nonprofit, Dividend Preference, and Reporting Investing Activities
 duration
 Appears in these related concepts: Disadvantages of the IRR Method, FloatingRate Bonds, and Comparing Price Risk and Reinvestment Risk
 equity
 Appears in these related concepts: Balance Sheets, Components of the Balance Sheet, and Introduction to the Retained Earning Statement
 interest rate
 Appears in these related concepts: SinglePeriod Investment, Greenspan Era, and Interest Rates and Economic Rationale
 investment
 Appears in these related concepts: The Upper Class, Defining Finance, and Shifts in investment due to shocks
 maturity
 Appears in these related concepts: Redeeming at Maturity, Amortized Cost Method, and Conflicts of Interest Between Shareholders and Bondholders
 premium
 Appears in these related concepts: Redeeming Before Maturity, The Freemium Model, and Health Care Reform
 principal
 Appears in these related concepts: MultiPeriod Investment, Types of Bonds, and Defining Agency Conflicts
 required return
 Appears in these related concepts: Calculating 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 these related concepts: Dollar Returns, Comparing the Fields of Finance, Economics, and Accounting, and Disadvantages of the Payback Method
 risk
 Appears in these related concepts: Portfolio Risk, Risks Involved in Capital Budgeting, and The Cost of Debt
 risk premium
 Appears in these related concepts: The Term Structure, Understanding Future Stock Value, and Measuring and Managing Risk
 yield
 Appears in these related concepts: Bonds Payable and Interest Expense, Stock Warrants, and Calculating the Yield of an Annuity
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Source: Boundless. “The "Bond Yield Plus Risk Premium" Approach.” Boundless Finance. Boundless, 01 Jul. 2015. Retrieved 01 Jul. 2015 from https://www.boundless.com/finance/textbooks/boundlessfinancetextbook/introductiontothecostofcapital10/approachestocalculatingthecostofcapital89/thebondyieldplusriskpremiumapproach3838734/