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Unformatted text preview: Aswath Damodaran 87 From Risk &amp; Return Models to Hurdle Rates: Estimation Challenges l The price of purity is purists z Anonymous Aswath Damodaran 88 Inputs required to use the CAPM  The capital asset pricing model yields the following expected return: Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio  Riskfree Rate) To use the model we need three inputs: (a) The current riskfree rate (b) The expected market risk premium (the premium expected for investing in risky assets (market portfolio) over the riskless asset) (c) The beta of the asset being analyzed. Aswath Damodaran 89 The Riskfree Rate and Time Horizon On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met There has to be no default risk , which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free. There can be no uncertainty about reinvestment rates , which implies that it is a zero coupon security with the same maturity as the cash ow being analyzed. Aswath Damodaran 90 Riskfree Rate in Practice The riskfree rate is the rate on a zero coupon government bond matching the time horizon of the cash Fow being analyzed. Theoretically, this translates into using different riskfree rates for each cash Fow  the 1 year zero coupon rate for the cash Fow in year 1, the 2year zero coupon rate for the cash Fow in year 2 ... Practically speaking, if there is substantial uncertainty about expected cash Fows, the present value effect of using time varying riskfree rates is small enough that it may not be worth it. Aswath Damodaran 91 The Bottom Line on Riskfree Rates Using a long term government rate (even on a coupon bond) as the riskfree rate on all of the cash Fows in a long term analysis will yield a close approximation of the true value. or short term analysis, it is entirely appropriate to use a short term government security rate as the riskfree rate. The riskfree rate that you use in an analysis should be in the same currency that your cashFows are estimated in. In other words, if your cashFows are in U.S. dollars, your riskfree rate has to be in U.S. dollars as well. If your cash Fows are in Euros, your riskfree rate should be a Euro riskfree rate. The conventional practice of estimating riskfree rates is to use the government bond rate, with the government being the one that is in control of issuing that currency. In US dollars, this has translated into using the US treasury rate as the riskfree rate. In May 2009, for instance, the tenyear US treasury bond rate was 3.5%. Aswath Damodaran 92 What is the Euro riskfree rate? Aswath Damodaran 93 What if there is no defaultfree entity?...
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This document was uploaded on 11/01/2011 for the course FINANCE 402 at NYU.
 Spring '11
 staff
 Capital Asset Pricing Model

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