You cannot ask investors for their cost of capital so

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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 + Default Premium Actual Return = Time Premium + Risk Realization + Default Realization...
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