What is the equity risk premium for small company stocks given the following assumptions: Return on small company stocks = 12%, Return on Treasury bonds = 5%, Inflation rate = 3%?

To determine the equity risk premium, you subtract the return on Treasury bonds from the return on small company stocks. The equity risk premium reflects the additional return that investors expect to earn from investing in riskier assets, such as stocks, compared to safer assets like Treasury bonds.

In this case, the return on small company stocks is 12%, and the return on Treasury bonds is 5%. By performing the calculation:

12% (return on small company stocks) - 5% (return on Treasury bonds) = 7%.

This results in an equity risk premium of 7%. This is significant because it highlights the compensation that investors demand for taking on the additional risk associated with investing in small company stocks compared to the relatively safer Treasury bonds.

The inflation rate is not directly relevant for calculating the equity risk premium in this scenario, as it does not affect the difference between the two return rates. It might be considered when evaluating the real returns over time but is not a factor in this particular calculation.