Equity Risk Premium (ERP) refers to the additional compensation an equity investor receives above the risk-free rate (which is normally the treasury bill rate) for investing in equity markets or privately held enterprises. The ERP is the rate of return added to a risk-free rate to reflect the additional risk an equity investor takes. ERP is the additional return over the risk-free instruments. In business valuation analysis the ERP is one of the main components for estimating the Weighted Average Cost of Capital (WACC) which is the discount rate business valuators apply to convert future economic earnings (cash flows) to the present value in the determination of the fair market value of a business entity. The other components of the WACC are the cost of debt and the risk-free rate which is the return on risk-free instruments such as the treasury bills. The computation of the cost of equity, showing the ERP is shown as:
Cost of Equity = Rf + bx(MRP)
Where:
Rf = Risk-Free Rate
bx = Beta
MRP = Market Risk Premium (the return on the stock exchange over a long period)
bx(MRP) = Equity Risk Premium