Chapter 9 - Chapter 9: 1. For a well-diversified investor,...

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Chapter 9: 1. For a well-diversified investor, based on the CAPM, what information is needed to estimate the cost of capital of a venture financial claim by the RADR method? Answer: You need estimates of the risk-free rate of return, the market rate or market risk premium, and the beta risk of the financial claim. 2. What do you think would be the best ways to get information to use the CAPM to estimate cost of capital for a well-diversified investor? Answer: The risk-free rate can be best estimated by using the currently available yield on a riskless debt instrument with a duration similar to that of the project. The market risk premium can be estimated most easily by using long-term historical averages on broad- based indexes, such as the S&P 500. Alternatively, and possibly more accurately, the market risk premium can be estimated prospectively by estimating the discount rate based on forecasts of long-run future dividend cash flows from a broad portfolio such as the S&P 500. Beta risk can be estimated by using historical returns data on market assets that are comparable to the financial claim being valued or by undertaking a fundamental analysis of beta risk, related to possible states of the economy. 3. What difficulties do you see in trying to use public market data to estimate the opportunity cost of capital for a financial claim that would be held by an underdiversified investor? Answer: Market data on total risk and systematic risk reflect the equilibrium holding period returns and risk for well-diversified investors. For an investor who must be underdiversified in order to invest in the asset, equilibrium holding period returns will be higher. Therefore, equilibrium total risk and systematic risk also will be higher. 4. For a well-diversified investor, based on the CAPM, what information is needed to estimate the present value of a venture financial claim by the CEQ method? Answer: The required information includes: the expected future cash flow and its timing, the standard deviation of future cash flows, the correlation between future cash flows and the market, the standard deviation of market returns over the same holding period, the risk- free rate, and the market rate or market risk premium.
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5. “Because the world is always changing, is it better to use the average of recent historical returns to estimate the market risk premium or to use a long-run average.” True, false, or uncertain? Explain. Answer: Uncertain (depending on the discussion). Short-run averages are subject to a high degree of estimation error, which error can be reduced by estimating over more years. On the other hand, averages over very long periods may introduce bias due to secular changes. For example, it is feasible that developments such as widespread use of portfolio theory, and professionalization of investment management may have reduced the market risk premium.
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Chapter 9 - Chapter 9: 1. For a well-diversified investor,...

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