The Equity Market Risk Premium (MARP) is a fundamental component in determining the profitability demanded by shareholders.

Here is its definition and its mechanism of influence on the cost of equity:

1. What is EMRP?

The EMRP (or Equity Market Risk Premium) is the extra return that investors demand to invest in the (risky) stock market rather than in an asset that is considered risk-free (usually government bonds).

• The principle: As investors are risk-averse, they only agree to invest in risky assets (shares) if they anticipate a higher return than a safe investment.
• The calculation: It is obtained by observing the average profitability of the stock market over a long period of time and subtracting the risk-free interest rate over the same period.
• Nature of the data: Although some practitioners attempt to calculate a forward-looking premium, it is recommended to use a historical EMRP calculated over a long period of time (several decades) to ensure stability, as the future does not always resemble the past. Academic sources, such as Professor Damodaran’s website, are often used to obtain reliable figures (e.g. 5.4% for the Indian market).

2. How does it influence the cost of equity?

The PRMA is the central variable of the CAPM (Capital Asset Pricing Model), which is used to calculate the cost of equity (E(ROE))
The influence is done via the following formula:

$\mathbf{E}\left(\mathbf{ROE}\right)={\mathbf{R}}_{\mathbf{F}}+\mathbf{ß}\times \mathbf{PRMA}$

Where:

• R_F (Risk-free rate): The price of time (remuneration for the immobilization of funds).
• ß (Beta): The company’s systematic risk coefficient (its sensitivity to market fluctuations).
• EMRP: The market risk premium.

Mechanism of influence:

1. Systematic risk compensation: The EMRP represents the price of risk for the overall market. The company’s cost of equity is therefore equal to the risk-free rate increased by a fraction or multiple of this EMRP, depending on the company’s level of systematic risk (measured by the Beta).
2. Multiplier effect: If the EMRP increases (because the market becomes more risk-averse overall), the cost of equity will increase for all companies, but the impact will be stronger for risky companies (High Beta) than for defensive companies.

3. Special case: The Country Risk Premium

In the case of an international investment, the standard EMRP may not be sufficient. If the project is located in a country with political or economic instability (non-diversifiable risk), a Country Risk Premium must be added to the equation.

This additional premium is often estimated via the CDS (Credit Default Swaps) rate of the sovereign debt of the country concerned. The formula then becomes:

$\mathrm{E}\left(\mathrm{ROE}\right)={\mathrm{R}}_{\mathrm{F}}+\mathrm{ß}\times \mathrm{PRMA}+\mathrm{Prime} \mathrm{Country}$