Description  |
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| Results |
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Risk Premium Model
Shortcomings, Caveats & Refinements
Shortcomings
- All the shortcomings of the DCF model are compounded in the simple risk premium model, since DCF is used to come up with the premium.
- Both the Simple Risk Premium and the CAPM model rely primarily on historical data to calculate the premium. This "backward-lookingness" is mitigated only partially by adding the premium to a forecasted interest rate.
- Choice of any particular historical period for use in providing the required input may appear to be arbitrary, subject to manipulation to achieve the desired result.
Caveats
- The risk premium model tends to overstate results in periods of high interest rates.
Refinements
- Should use a forecasted cost of debt, not actual debt cost, to make the result forward looking.
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