Which of the following statements is correct?
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Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, then decision makers can have more confidence in the estimated cost of equity.
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The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because the DCF modelcorrectly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield and accurate estimates for its key inputs are easy to obtain.
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The bond-yield-plus-risk-premium approach to estimating the cost of equity is always accurate, because its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures.
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Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs—beta, the risk-free rate, and the market risk premium—can be estimated with no error.
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