Final answer:
The bond yield plus risk premium approach is used to estimate the cost of equity by adding a risk premium to the bond yield to account for greater risks compared to stable government bonds. It helps determine the appropriate rate of return for an investment by considering the present value of expected future cash flows and market interest rates, similar to the capital asset pricing model.
Step-by-step explanation:
The bond yield plus risk premium (BYPRP) approach is useful for estimating the cost of equity in a company. This method is akin to the capital asset pricing model (CAPM), which is utilized to determine a theoretically appropriate required rate of return for an asset, considering the asset's risk as compared to the overall market risk.
The BYPRP approach combines the bond yield with an additional risk premium, the latter of which accounts for the stock's risk over and above that of a government bond. This premium reflects the additional return that investors require to bear additional risk. Financial investors differ in opinion concerning the level of risk and potential return, and this influences their investment choices, such as whether to buy or sell a stock based on its expected capital gains or dividend payments.
When it comes to bonds, the price of a bond is always the present value of its expected future cash flows, which includes interest payments and the return of principal. Factors like the interest rate prevailing in the market and a borrower's creditworthiness (which affects the risk of default) influence the bond yield and thus, the calculation of a bond's price.