Unformatted text preview: instead of
funding new projects. • You cannot ask investors for their cost of capital, so
you make some assumptions about them:
— They are smart (Oh God, how naive can ﬁnance be!)
— They like reward and dislike risk.
— They use the expected return as a measure of
reward and variance as a measure of risk.
— They hold diversiﬁed portfolios, i.e., some combination of the market mutual fund and the riskfree asset.
— They are cold-hearted people, so they couldn’t
care less about you or your employees. They
only care about how your project choices impact
their overall portfolio. Aside: Does this apply to family
ﬁrms, or ﬁrms with highly concentrated ownership, which
are the standard around the world except for the Anglosaxon world? • If these assumptions apply (well, the coldheartedness
is optional), then the CAPM is a good benchmark
for your investors’ opportunity cost. • Remember: the alternative investment strategy that
the CAPM suggests is to invest β % of the portfolio
in the market and (1 − β )% in the risk-free asset.
That is the next best alternative. • Remember the following formulas:
Expected Return = Time Premium + Risk Premium
Promised Return = Time Premium + Risk Premium +
Actual Return = Time Premium + Risk Realization +
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- Fall '08
- Capital Asset Pricing Model, CAPM formula