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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

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.
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 Plus Risk Premium Equation
States that the required return on an equity equals the yield of the company's longterm debt plus the equity's risk premium.
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).
Yield To Maturity Graph
A hypothetical graph showing yield to maturities (or internal rates of return) for corresponding present values.
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.
Example Equation
Required return = 6% + 4%
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Key Term Reference
 Assets
 Appears in these related concepts: Defining LongLived Assets, Defining the Marketing Objectives, and Secured vs. Unsecured Funding
 Interest
 Appears in these related concepts: Your Areas of Interest, Interest Compounded Continuously, and Tax Considerations
 Stock
 Appears in these related concepts: Control and Preemption, Ownership Nature of Stock, 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, Default Risk and Bond Price, 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: Writing in Different Academic Disciplines, Scenario Analysis, and The Importance of Rehearsing
 asset
 Appears in these related concepts: Balance Sheets, The Demand for Money, and Shifts in the Money Demand Curve
 bond
 Appears in these related concepts: Conflicts of Interest Between Shareholders and Bondholders, Preferred Stock, and Credit Ratings
 capital
 Appears in these related concepts: Other Factors of Production, Moving from ShortRun to LongRun, and Defining Capital
 cash flow
 Appears in these related concepts: Cash Flow, Interpreting the NPV, and Interpreting Overall Cash Flow
 debt
 Appears in these related concepts: Debt Utilization Ratios, Deficit Spending, the Public Debt, and Policy Making, and Collection from Delinquent Payables
 discount
 Appears in these related concepts: The Discount Rate, Time to Maturity, and Present Value, Multiple Flows
 discount rate
 Appears in these related concepts: Discounted Cash Flow Approach, The Federal Reserve and the Financial Crisis of 2008, and The Discount Rate
 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: Investor Preferences, Performance per Share, and Accounting for Preferred Stock
 duration
 Appears in these related concepts: FloatingRate Bonds, Comparing Price Risk and Reinvestment Risk, and Disease Severity and Duration
 equity
 Appears in these related concepts: Civil Law and Criminal Law, Trading off Equity and Efficiency, and The Psychology of Employee Satisfaction
 interest rate
 Appears in these related concepts: The Equilibrium Interest Rate, Interest Rates and Economic Rationale, and Determinants of investment
 investment
 Appears in these related concepts: The Role of the Financial System, GDP Equation in Depth (C+I+G+X), and Shifts in investment due to shocks
 maturity
 Appears in these related concepts: Accounting for Interest Earned and Principal at Maturity, Maturity, and The Cost of Debt
 premium
 Appears in these related concepts: The Freemium Model, Health Insurance, and Health Care Reform Under Obama
 principal
 Appears in these related concepts: Types of Bonds, Maximizing Shareholder and Market Value, and Formulas and ProblemSolving
 required return
 Appears in these related concepts: Calculating Yield to Maturity Using the Bond Price, Impact of Dividend Policy on Clientele, and Differences Between Required Return and the Cost of Capital
 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: Approaches to Assessing Risk, Portfolio Risk, and Risks Involved in Capital Budgeting
 risk premium
 Appears in these related concepts: Understanding Future Stock Value, Measuring and Managing Risk, and The Value of Diversification
 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, 21 Jul. 2015. Retrieved 12 Feb. 2016 from https://www.boundless.com/finance/textbooks/boundlessfinancetextbook/introductiontothecostofcapital10/approachestocalculatingthecostofcapital89/thebondyieldplusriskpremiumapproach3838734/