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Unformatted text preview: J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Risk and Investment Decisions Week 8: April 19, 2010 (LA), or April 20, 2010 (OCC) J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Risk and Investments ◆ All value in finance is present value of expected future cash flows discounted at the riskadjusted discount rate ◆ Estimating expected future cash flows as in Baldwin example (Chapter 6) or Sheet II of PVFIRM06 ◆ CAPM is one way to choose a discount rate which we explore this week J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Expected versus Required Rate ◆ Investors require compensation for systematic risk ◆ If expected returns from a project or an asset is higher than the required rate, it has positive net present value ◆ Equivalently, its internal rate of return is higher than the opportunity rate ◆ Security market line is relation between systematic risk and required rates in CAPM J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Security Market Line (SML) Systematic Risk Expected Return R F β =1 R M SML × × × × × × × × ⊗ ⊗ ⊗ ⊗ ⊗ ⊗ ⊗ ⊗ E(R) > Required Rate Accept Reject E(R) < Required Rate J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Estimating the Cost of Equity ◆ The cost of equity is extremely important and all methods of estimating it may be biased or misleading ◆ The only option is to estimate expected returns several ways ◆ We explore three ways: – CAPM (by far the most common) – Reviewing past performance – The dividendgrowth model J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010 Cost of Equity Capital (CAPM): 1 ◆ Easily computed – but need to know equity risk premium ◆ Equity risk premium historically in U.S. 7.9% (Table 10.2) ◆ Use riskfree rate and premium on average stock, in text Treasury bill rate and argument supporting using equity risk premium estimated at 7% (see discussion at p. 358) ◆ For stock i with a given beta (equation 11.16, p. 359) ◆ Need only know a stock’s beta and the equity risk premium, and easily observable Treasury (or other risk free rate ) R R R R i F i M F = +  β ( ) J. K. Dietrich  GSBA 548 – MBA.PM Spring 2010J....
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This note was uploaded on 02/11/2012 for the course FBE 443 taught by Professor Imrohoroglu during the Spring '07 term at USC.
 Spring '07
 Imrohoroglu

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