Which of the following methods for calculating the cost of equity ignores risk?

• A. Capital Asset Pricing Model (CAPM)
• B. Bond Yield Plus Risk Premium Method
• C. Dividend Yield Method
• D. Arbitrage Pricing Theory (APT)

Answer: (C)

Verified step by step guidance

1. Understand the concept of cost of equity: Cost of equity represents the return a company must offer investors to compensate them for the risk of investing in its equity. Different methods are used to calculate this, and some incorporate risk while others do not.
2. Review the Capital Asset Pricing Model (CAPM): CAPM calculates the cost of equity by considering the risk-free rate, the equity beta (which measures risk relative to the market), and the market risk premium. Since it explicitly incorporates risk, it does not ignore risk.
3. Examine the Bond Yield Plus Risk Premium Method: This method adds a risk premium to the yield of the company's bonds to estimate the cost of equity. It accounts for risk by including the risk premium, so it does not ignore risk.
4. Analyze the Dividend Yield Method: This method calculates the cost of equity by dividing the annual dividend per share by the current market price of the stock. It does not explicitly account for risk, as it focuses solely on the dividend yield, making it the method that ignores risk.
5. Consider Arbitrage Pricing Theory (APT): APT is a multi-factor model that calculates the cost of equity based on various risk factors. Since it incorporates risk factors, it does not ignore risk.