Abstract
Since the equity premium puzzle was identified by Mehra and Prescott (1985), many papers in this literature has started to discuss this phenomenon and the subsequent problem- risk-free rate puzzle. In accordance with standard asset-pricing theory, if we want to estimate precisely asset prices, it’s necessary for us to calculate correctly the appropriate discount factor and the future cash flow. Unfortunately, many scholars often discuss the equity premium puzzle from the only one viewpoint. Therefore we apply habit formation model to estimate the discount factor and model the cash flow by allowing aggregate dividends to differ from aggregate consumption. In benchmark scenario, we also show that the jump in surplus consumption ratio plays a critical role in expounding the equity premium puzzle and the risk-free rate puzzle.