Previous chapters discuss the cost of capital in terms of its two major components: a risk-free rate for the time value of money and a risk premium for the risk- profile of the benefits stream. This chapter examines these components in general, dividing the equity risk premium into three principal subcomponents. The typical build-up model for estimating the cost of common equity capital has two primary components, with one of them having three subcomponents:
- Risk-free rate
- Premium for risk, including any or all of these subcomponents:
- General equity risk premium
- Small-company risk premium
- Company-specific risk premium
In international investing, there may also be a country-specific risk premium, reflecting uncertainties owing to economic and political instability in the particular country to the extent that those rises are greater than in the United States. We discuss the cost of capital in developing economies in Chapter 39.