Certified Valuation Analyst (CVA) Practice Exam

Which models are most commonly used for estimating the cost of equity capital?

1. Discounted Cash Flows and Residual Income

2. Income Approach and Market Approach

3. Ibbotson Build-Up Method and CAPM

4. Dividend Discount Model and Earnings Growth Model

The correct answer is: Ibbotson Build-Up Method and CAPM

The Ibbotson Build-Up Method and the Capital Asset Pricing Model (CAPM) are two of the most widely used models for estimating the cost of equity capital because they offer complementary approaches to understanding the risk and return dynamics associated with equity investments. The CAPM specifically quantifies the relationship between systematic risk (market risk) and expected return, providing a framework to derive the expected return on an equity security based on its beta, the risk-free rate, and the market premium. This model is grounded in the notion that investors require additional returns for taking on additional risk, making it a cornerstone in finance for estimating the cost of equity. On the other hand, the Ibbotson Build-Up Method takes a more straightforward approach by starting with a risk-free rate and adding various risk premiums, including a market risk premium and firm-specific risk premiums. This model is particularly useful in situations where data on beta may not be readily available or where specific risk factors for a business can be identified. Together, these methods are favored by analysts for their robustness and the ability to encompass different perspectives on risk and return, making option C the best choice among the listed possibilities.