If the cost of common stock is 16% and the bond yield is 9%, what is the bond risk premium?

In Finance MCQs, the bond risk premium is an important concept that highlights the relationship between risk and return in corporate finance and investment analysis. It represents the additional return investors require for investing in common stock instead of relatively safer debt instruments such as bonds. Since equity carries higher risk than debt, investors demand compensation in the form of a higher expected return. This additional compensation is known as the bond risk premium.

The bond risk premium is calculated using the simple formula:

Bond Risk Premium = Cost of Common Stock − Bond Yield

In this question, the cost of common stock (also called the cost of equity) is 16%, and the bond yield is 9%. Applying the formula:

16% − 9% = 7%

Therefore, the bond risk premium is 7%. This 7% represents the extra return investors expect for bearing the additional risk associated with equity compared to bonds.

To understand why this makes financial sense, it is important to recognize the risk hierarchy in capital structure. Bonds are generally considered less risky than common stock for several reasons. Bondholders receive fixed interest payments and have priority over shareholders in case of liquidation. Shareholders, on the other hand, receive dividends only if profits are available and are paid after bondholders. Because of this lower priority and income uncertainty, equity is inherently riskier than debt.

The concept of bond risk premium is closely related to the Capital Asset Pricing Model (CAPM). In CAPM, the required return on equity depends on systematic risk (beta) and the market risk premium. The bond risk premium serves as a simplified way to compare equity returns with debt returns. It reflects how much extra return investors demand above the bond yield to justify investing in stocks.

This concept is also essential when calculating the Weighted Average Cost of Capital (WACC). WACC combines the cost of equity and the after-tax cost of debt to determine a firm’s overall cost of capital. Since equity is typically more expensive than debt, the bond risk premium helps explain why the cost of equity is higher and influences overall capital budgeting decisions.

Now, let us briefly examine why the other options are incorrect:

8% (Option B): This could result from a calculation error or misinterpretation of the formula. However, the correct subtraction of 9% from 16% gives 7%, not 8%.

1.78% (Option C): This value is unrelated to the bond risk premium formula. It may arise from confusion with ratios or other financial metrics, but it does not represent the difference between equity and bond returns.

25% (Option D): This figure is unrealistically high given the provided numbers. It would imply either incorrect addition or misunderstanding of the calculation method.

From a practical standpoint, understanding bond risk premium helps investors evaluate whether the additional return from stocks adequately compensates for higher volatility and uncertainty. Portfolio managers use this concept to make asset allocation decisions between equity and fixed-income securities. Corporate finance professionals use it to assess investor expectations and determine appropriate hurdle rates for projects.

In conclusion, the bond risk premium is calculated as the cost of common stock minus the bond yield. With a cost of equity of 16% and a bond yield of 9%, the bond risk premium equals 7%. Therefore, in Finance MCQs, the correct answer is 7%, making option A the right choice.