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This is not hard remember that the rm is like a

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Unformatted text preview: function. • CAREFUL: use betas that are adjusted for leverage or unlevered betas. You are empirically computing betas with equity, but you want firm-level betas to plug into the NPV formula. • This is not hard: remember that the firm is like a portfolio of debt and equity and betas can be valueweighted in a portfolio: β firm = Lβ debt + (1 − L)β equity • Where L is leverage, i.e., market value of debt over market value of total assets (debt + equity). • If default is not correlated with market swings (hard to swallow this assumption nowadays) then β debt ≈ 0, which implies: β firm ≈ (1 − L)β equity 2.3 Equity Premium • The equity premium is the average return on the market minus the average risk free rate. • The historical equity premium (1926-2002) is about 6%. • Some people claim this number is too big and we should expect a lower equity premium in the coming years. • What you’ll see in the press or hear among finance professors: 2% to 5% per year. • Everyone agrees that the standard deviation is substantially higher than the mean, on the order of 15% to 20% per year. – Q20: What...
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