According to the capital asset pricing model:
Ri = RF + (RM − RF) × bi
where Ri, the expected return on security i, is the sum of RF, the return on a risk-free investment, and (RM − RF) × bi is the expected extra return over the risk-free rate for taking on the risk of holding the security. bi measures the relative sensitivity of the security’s returns to changes in the return of a market index. RM is the expected return on a market index, and (RM − RF) is the difference between the expected market return and the risk-free rate, otherwise known as the market risk premium. In recent years, there has been considerable debate about the size of the market risk premium. Most textbooks, including this one, give a range between 4 percent and 6 percent. However, some of the major investments banks are using market risk premium as low as 3 percent when they are computing the cost of capital for valuing a company in mergers or other transactions.
How could rates as low as 3 percent be justified? What are the possible arguments used by the banks? If you were buying another company, would you agree to such a low rate? What if you were the selling firm?

  • CreatedMarch 27, 2015
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