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 ﬁrmlevel 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 (19262002) 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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 Fall '08
 FranciscoDeBorjaLarrain
 Capital Asset Pricing Model, CAPM formula

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