Which of the Following Statements Is CORRECT

question 63

Multiple Choice

Which of the following statements is CORRECT?

• A) 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 little error.
• B) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are
• C) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures.
• D) 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, this increases the decision maker's confidence in the estimated cost of equity.
• E) The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

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Definitions:

Unsystematic Risk

The risk associated with a specific company or industry that can be mitigated through diversification.

Residuals

Residuals are differences between observed and predicted values in statistical models, used to assess the fit of models to data.

Market Portfolio

A theoretical portfolio consisting of all assets available in the market, weighted by their market capitalization.

Efficient Frontier

A set of optimal portfolios offering the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.