Expectation of Constant Business Plan

• By using historic comparisons to risk free rates, the risk premium method assumes that the company will remain in the same line of business. Often this is a reasonable assumption, but it is not always true. For example, IBM switched from selling computer equipment to become more of a consulting firm. The risk premia for the two lines of business are likely to be different, so, looking at historic data could suggest inaccurate results.
  
  

Assumes All Returns Are Comparable

• The risk premium method does not differentiate between the returns received as dividends and those derived from increases in the price of a stock. At a theoretical level, this is quite reasonable because retain earnings should increase the value of the stock in an amount identical to the benefit that would have been received by the recipient of a dividend. However, in reality, stock prices do not always match this theory. Dividends are lower in risk than increases in stock price.
  
  

Risk Premium Assumes Debt to Equity Ratio is Constant

• Similar to the assumption that the business remains in the same industry, the risk premium method assumes that the company retains the same debt to equity ratio. However, a company may increase its use of debt, in which case the risk premium should increase, or reduce the use of debt and therefore lower the risk premium. The debt to equity ratio can significantly affect the returns on an investment, yet this is not addressed in the risk premium.
  
  

Risk Premium Does Not Consider Changes in Profits

• The risk premium method does not consider the impact of changes in earnings on the value of an investment in a company. This is not a major problem for regulated industries where earnings are predictable. However, the vast majority of businesses are not regulated and earnings may vary considerably. The anticipated returns from a company that is growing quickly are higher than a company that is earning less and less.
  
  

Countervailing Impacts of Interest Rates

• The risk premium method assumes that required returns on an investment will increase with increases in interest rates. This makes sense because investors will shift to other investments if they are not rewarded for taking on risk. However, increases in interest rates also can increase the costs of doing business because the interest expenses incurred by the business are likely to increase. This can reduce the net income of the business. Consequently, there is a disconnect--investors will demand higher returns as interest rates increase and the costs of doing business simultaneously can increase making higher returns more difficult to achieve.