What is the Market Risk Premium (MRP)?
The Market Risk Premium (MRP) represents the additional return that market investors demand for taking on the higher risk of investing in the stock market compared to risk-free assets. It is essentially a measure of the reward for bearing higher risk.
Where:
Expected Market Return: The return investors expect from a broadly diversified market portfolio.
Risk-Free Rate: The return on a theoretically risk-free investment, typically long-term government bonds.
How is the Market Risk Premium Used in WACC?
The MRP is a vital component in the Capital Asset Pricing Model (CAPM), which is used to calculate the rₑ: Cost of Equity:
Determining Cost of Equity:
The MRP, in conjunction with the risk-free rate and βₑ: Levered Beta, determines the equity investors’ expected return.
Incorporation into WACC:
Once the Cost of Equity is calculated, it feeds into the WACC formula:
The higher the MRP, the greater the Cost of Equity, which increases the WACC.
Why is the Market Risk Premium Important in WACC?
Measures Risk-Return Tradeoff:
The MRP quantifies the compensation investors expect for bearing market-wide risk, which cannot be diversified away.
Direct Impact on WACC:
Higher MRP leads to a higher Cost of Equity, raising the overall WACC. A lower MRP has the opposite effect.
Reflects Market Sentiment:
The MRP reflects the broader economic environment and investor expectations. For example:
During periods of high market uncertainty, the MRP tends to increase as investors demand higher returns for risk.
In stable markets, the MRP may decrease.
Benchmark for Investment Decisions:
Companies use WACC as a hurdle rate for investments. A higher MRP raises the WACC, making fewer projects viable, while a lower MRP can encourage investment.