ECON 3420 Discussion 2

ECON 3420 Discussion 2 - ECON 3420A Financial Economics...

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ECON 3420A Financial Economics 2010-2011 Term 1 Discussion 2: Capital Asset Pricing Model (CAPM) 1. Recall the PV rule of investment decision. Extend that rule to investment decisions under risk, in the light of the CAPM. The PV rule for investment decision is used to discount future cash payments so cash flows from different dates can be added up together. Market interest rate (r) is used in discounting future earnings, i.e. Without risk, the opportunity cost of investing in a certain project is the interest rate that can be earned by putting the money in banks (r). Under risk, the opportunity cost of investing in a certain project is the return forgone from investing in another project (or portfolio) with the same β (same risk). The expected return of this project, say r' getting from CAPM equation, is used for discounting. This r' is the required rate of return. Therefore under risk, r' is used to discount future income and the equation becomes If NPV is positive, the project (portfolio) is accepted but if NPV is negative it should not be accepted. n n r C r C r r C C NPV ) 1 ( ...... ) 1 ( ) 1 ( 0 ) 1 ( 3 3 2 1 0 + + + + + + + + - = n n r C r C r r C C NPV ) ' 1 ( ...... ) ' 1 ( ) ' 1 ( 0 ) ' 1 ( 3 3 2 1 0 + + + + + + + + - =
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Alternative version: In the Present Value rule of investment decision, market interest rate is used to discount the expected future cash flow of a project to obtain the Net Present Value, in the sense that the opportunity of investing money into this project is the interest generated by depositing the money into the bank and earn a profit at the market interest rate. If the Net Present Value obtained is positive, the project will be accepted. Otherwise, it will be rejected. In Investment Decision under risk, the opportunity cost of investing in this project is the return foregone of a portfolio with the same level of risk since it is assumed investors are all holding a well-diversified portfolio. Investors make use of the CAPM to find out the expected rate of return corresponding to the beta risk of the project from the security market line first. Next, investors have to manipulate the required rate of return to discount the future cash flow, and calculate the net present value of the project. Finally, the project will be accepted if the Net Present Value is positive. Otherwise, it will be rejected. In short, if the project cannot generate a profit higher than a portfolio with the same level of risk, investors will have no reason and no incentive to invest such a project.
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2. A venture capital is a sum of investment capital that is controlled by a fund manager. The capital is raised from institutional investors (pension funds, insurance companies, etc.) The fund manager’s job is to find suitable targets to invest in and hopefully generate significant returns to the investors. The typical life of a venture capital fund is 10 years. When the manager makes a decision on an investment target, (s)he typically relies on CAPM. (S)he would estimate a beta
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ECON 3420 Discussion 2 - ECON 3420A Financial Economics...

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