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Rob's e2700 Notes

🔎 What is a risk premium?

In this chapter, we heavily use expected returns.

  • The expected return on unlevered equity is called the cost of capital of unlevered equity.
  • The expected return on levered equity is called the cost of capital of levered equity.

While the expected return and the cost of capital are synonyms, a risk premium is defined as the difference between an expected return and the risk free rate: (From Lecture 7)

According to the above slide, Risk  premium=Expected  return−risk  free  rateRisk \;premium = Expected \;return - risk \;free \;rate

If you add the risk free rate to both sides, you get

Expected  return=Risk  Premium+Risk  Free  RateExpected \;return = Risk \;Premium + Risk \;Free \;Rate

Bringing it all together, we get that:

Discount  Rate=Cost  of  Capital=Expected  return=Risk  premium+risk  free  rate\begin{aligned} Discount \;Rate &= Cost \;of \;Capital \\ &= Expected \;return \\ &= Risk \;premium + risk \;free \;rate \end{aligned}