DISCOUNTING

CASH FLOWS

RISKY DETERMINISTIC

DISCOUNT USING
DISCOUN

RISK-ADJUSTED THE RISK-FREE RATE

CERTAINTY EQUIVALENT
DISCOUNTED RATE OF CASH FLOW
 RISKY

RISK-ADJUSTED CERTAINTY EQUIVALENT

DISCOUNTED RATE OF CASH FLOW
 RISKY

RISK-ADJUSTED CERTAINTY EQUIVALENT

DISCOUNTED RATE OF CASH FLOW

“CERTAINTY EQUIVALENT” IS NOT

THE SAME AS “EXPECTED VALUE”

THE MOST PRACTICAL WAY OF CALCULATING THE CERTAINTY EQUIVALENT

INVOLVES USING A RISK-ADJUSTED RATE, SO NOBODY BOTHERS :-)
 RISKY

RISK-ADJUSTED CERTAINTY EQUIVALENT

DISCOUNTED RATE OF CASH FLOW
 RISKY

RISK-ADJUSTED CERTAINTY EQUIVALENT

DISCOUNTED RATE OF CASH FLOW

RISK-ADJUSTED DISCOUNT RATES

ARE USED FAR MORE OFTEN
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE

DISCOUNT RATE = RATE AT WHICH WE WILL DISCOUNT FUTURE

CASH FLOWS FROM THAT ASSET TO FIND THEIR PRESENT VALUE
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE

RATE OF RETURN = % CHANGE BETWEEN FINAL AND

INITIAL VALUE, LIKE WITH A TERM DEPOSIT
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE

IF WE KNEW, BEFOREHAND, THE EXACT RATE OF RETURN,

IT WOULD BE EXACTLY THE RIGHT RATE TO USE
WE PROVED THIS WITH THE TERM DEPOSIT EXAMPLE
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE

THIS IS WHY, FOR A DETERMINISTIC ASSET, IT MAKES SENSE

TO USE THE RISK-FREE RATE
BECAUSE FOR ANY DETERMINISTIC ASSET, THE RATE OF RETURN HAS
TO BE EXACTLY THE RISK FREE RATE (ELSE THERE IS AN ARBITRAGE)
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

SO USE OUR CURRENT BEST ESTIMATE, WHATEVER THAT IS!

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE

NOW, FOR RISKY ASSETS, WE DON’T KNOW THE RETURNS

BEFOREHAND..
..THAT’S THE DEFINITION OF A RISKY ASSET :-)
 RISK-ADJUSTED DISCOUNT RATES
ARE USED FAR MORE OFTEN

THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR BEST

ESTIMATE OF THE RETURNS THAT ASSET WILL GENERATE
 BEST ESTIMATE OF THE RETURNS THAT
THE DISCOUNT RATE FOR ANY ASSET SHOULD BE OUR

ASSET WILL GENERATE

IN GENERAL, ASSETS WITH THE SAME RISK

SHOULD HAVE THE SAME RETURN

(IF NOT, THERE WILL BE AN ARBITRAGE, AND

THE PRICES OF THOSE ASSETS WILL CONVERGE)
IN GENERAL, ASSETS WITH THE SAME RISK
SHOULD HAVE THE SAME RETURN

AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS

THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN
AND SO, FOLKS HAVE PUT A LOT OF EFFORT
BUILDING MODELS THAT GIVEN THE RISK OF
AN ASSET, PREDICT ITS RETURN

A MATH MODEL - SOMETHING GOES IN,

SOMETHING COMES OUT
AND SO, FOLKS HAVE PUT A LOT OF EFFORT
BUILDING MODELS THAT GIVEN THE RISK OF
AN ASSET, PREDICT ITS RETURN

WHAT GOES IN? RISK OF THE ASSET

AND SO, FOLKS HAVE PUT A LOT OF EFFORT
BUILDING MODELS THAT GIVEN THE RISK OF
AN ASSET, PREDICT ITS RETURN

HOW IS RISK DEFINED? DIFFERENTLY BY

DIFFERENT MODELS
AND SO, FOLKS HAVE PUT A LOT OF EFFORT
BUILDING MODELS THAT GIVEN THE RISK OF
AN ASSET, PREDICT ITS RETURN

WHAT COMES OUT? A PREDICTION OF

RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT
BUILDING MODELS THAT GIVEN THE RISK OF
AN ASSET, PREDICT ITS RETURN

USUALLY, THIS PREDICTION ALSO DEPENDS ON THE RISK FREE RATE,

WHICH IS ANOTHER INPUT (IN ADDITION TO THE ASSET’S RISK)
AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN
AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

RETURN EXPECTED
RISK MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN
ASSET
CHARACTERISTICS
RISK
MODEL
INPUTS
RISK
RISK-FREE
RATE RETURN EXPECTED
MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL OUTPUTS
RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS

RISK RETURN MODEL

MODEL

RISK

RISK-FREE
EXPECTED
RATE RETURN
 AND SO, FOLKS HAVE PUT A LOT OF EFFORT BUILDING MODELS
THAT GIVEN THE RISK OF AN ASSET, PREDICT ITS RETURN

ASSET
CHARACTERISTICS

RISK RETURN MODEL

MODEL

RISK

RISK-FREE
EXPECTED
RATE RETURN
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY
 RISKY DEBT

THIS IS THE DEBT OF A COMPANY OR ENTITY THAT

HAS SOME NON-ZERO PROBABILITY OF DEFAULT

TYPICALLY, FIRMS WITH THE SAME CREDIT RATING PAY

SIMILAR RATES OF INTEREST FOR A GIVEN BOND TENOR
 RISKY DEBT
THIS IS THE DEBT OF A COMPANY OR ENTITY THAT HAS
SOME NON-ZERO PROBABILITY OF DEFAULT

TYPICALLY, FIRMS WITH THE SAME CREDIT RATING PAY

SIMILAR RATES OF INTEREST FOR A GIVEN BOND TENOR
THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

THE MODEL INPUTS ARE 2 ASSET

CHARACTERISTICS: CREDIT RATING AND MATURITY
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

THE MODEL INPUTS ARE 2 ASSET

CHARACTERISTICS: CREDIT RATING AND MATURITY
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

THE MODEL INPUTS ARE 2 ASSET

CHARACTERISTICS: CREDIT RATING AND MATURITY
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

THE MODEL OUTPUT IS THE CORRESPONDING RISK

PREMIUM (SPREAD OVER RISK-FREE TREASURIES)
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

THE MODEL OUTPUT IS THE CORRESPONDING RISK

PREMIUM (SPREAD OVER RISK-FREE TREASURIES)
 THIS TABLE IS A SIMPLE RISK-RETURN
MODEL FOR RISKY DEBT

TO FIND THE DISCOUNT RATE, SIMPLY ADD THIS RISK

PREMIUM TO THE CORRESPONDING RISK-FREE RATE
ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
 CREDIT RATING,
MATURITY OF DEBT
ASSET
RISK
MODEL

RISK

RETURN EXPECTED
RISK- EXPECTED RETURN
FREE MODEL RETURN
OF THIS DEBT
TREASURY YIELD
(RISK-FREE RATE)
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY

THIS IS A MORE COMPLICATED

TOPIC, LET’S GET TO IT
 EQUITY (SHARES) OF A NO-DEBT FIRM

SHARES IN A COMPANY ARE AN ASSET

THEY ENTITLE THE OWNER TO FUTURE

ECONOMIC BENEFITS:

SHARE PRICE
DIVIDENDS BUYBACKS APPRECIATION
 SHARES IN A COMPANY ARE AN ASSET
THEY ENTITLE THE OWNER TO FUTURE ECONOMIC BENEFITS:

SHARE PRICE
DIVIDENDS BUYBACKS APPRECIATION

SO, LIKE ANY ASSET, A SHARE

IN A COMPANY HAS AN NPV
SO, LIKE ANY ASSET, A SHARE
IN A COMPANY HAS AN NPV

AND, IF WE CAN CALCULATE THE NPV OF 1 SHARE, WE

CAN CALCULATE THE NPV OF THE ENTIRE COMPANY

AND THAT NPV IS THE INTRINSIC

VALUE OF THE COMPANY
 AND THAT NPV IS THE INTRINSIC
VALUE OF THE COMPANY

WHAT CASH FLOWS TO DISCOUNT?

WHAT DISCOUNT RATE TO USE?

 AND THAT NPV IS THE INTRINSIC
VALUE OF THE COMPANY

LET’S FOCUS ON THIS

WHAT CASH FLOWS TO DISCOUNT?
QUESTION FOR NOW
WHAT DISCOUNT RATE TO USE?
 DISCOUNTING EQUITY CASH FLOWS

RISKY DETERMINISTIC

DISCOUNT USING
DISCOUN

RISK-ADJUSTED THE RISK-FREE RATE

CERTAINTY EQUIVALENT
DISCOUNTED RATE OF CASH FLOW
 DISCOUNTING EQUITY CASH FLOWS

RISKY

RISK-ADJUSTED CERTAINTY EQUIVALENT

DISCOUNTED RATE OF CASH FLOW
 DISCOUNTING EQUITY CASH FLOWS

RISKY

RISK-ADJUSTED RISK RETURN MODELS

DISCOUNTED RATE FOR EQUITY STOCKS
 RISK RETURN MODELS FOR EQUITY STOCKS

ASSET
CHARACTERISTICS
RISK
MODEL

RISK

RETURN EXPECTED
RISK-FREE
RATE MODEL RETURN
THERE ARE LOTS AND LOTS (AND LOTS) OF
RISK RETURN MODELS FOR
EQUITY STOCKS
THERE ARE LOTS AND LOTS (AND LOTS) OF
RISK RETURN MODELS FOR
EQUITY STOCKS

BUT BY FAR THE MOST FAMOUS IS:

THE CAPITAL ASSET
PRICING MODEL
CAPM
 THE CAPITAL ASSET
PRICING MODEL
CAPM
LIKE ANY RISK-RETURN MODEL, THE CAPM TAKES IN ASSET
CHARACTERISTICS, AND GIVES OUT AN EXPECTED RETURN

THE ONLY ASSET CHARACTERISTIC

THE CAPM CARES ABOUT IS
MARKET BETA
IF THE MARKET MOVES BY 1%, BY
HOW MUCH WILL A STOCK MOVE?
OF THE STOCK
 MARKET BETA OF THE STOCK
IF THE MARKET MOVES BY 1%, BY HOW MUCH WILL A PARTICULAR STOCK MOVE?

BETA IS A WIDELY USED AND EASILY UNDERSTOOD MEASURE

- YAHOO FINANCE REPORTS BETAS, FOR INSTANCE
MARKET BETA OF THE STOCK
MARKET BETA OF THE STOCK
 MARKET BETA OF THE STOCK

IF THE MARKET MOVES BY 1%, BY HOW

MUCH WILL A PARTICULAR STOCK MOVE?
 MARKET BETA OF THE STOCK

IF THE MARKET MOVES BY 1%, BY HOW

MUCH WILL A PARTICULAR STOCK MOVE?

PRACTICALLY, MARKET = A BROAD, DIVERSIFIED

MARKET INDEX LIKE THE S&P 500
 MARKET BETA OF THE STOCK

IF THE MARKET MOVES BY 1%, BY HOW

MUCH WILL A PARTICULAR STOCK MOVE?

REMEMBER, A STOCK HAS A PRICE, AND THAT

PRICE WILL CHANGE WHEN THE MARKET MOVES
 MARKET BETA OF THE STOCK

IF THE MARKET MOVES BY 1%, BY HOW

MUCH WILL A PARTICULAR STOCK MOVE?

CLEARLY, THE ANSWER TO THIS QUESTION IS A MEASURE OF

HOW CLOSELY A STOCK MIRRORS THE MARKET AS A WHOLE
“MARKET BETA IS A MEASURE OF THE CO-
MOVEMENT OF A STOCK WITH THE INDEX”
 MARKET BETA OF THE STOCK

IF THE MARKET MOVES BY 1%, BY HOW

MUCH WILL A PARTICULAR STOCK MOVE?

ERRM..SURELY THERE ARE OTHER FACTORS (OTHER

THAN THE MARKET) THAT WILL INFLUENCE THE STOCK?
 MARKET BETA OF THE STOCK
IF THE MARKET MOVES BY 1%, BY HOW MUCH WILL A
PARTICULAR STOCK MOVE?

ERRM..SURELY THERE ARE OTHER FACTORS (OTHER THAN THE

MARKET) THAT WILL INFLUENCE THE EXPECTED RETURN OF THE STOCK?

NOPE, IN THE CAPM, THE ONLY FACTOR THAT DETERMINES

EXPECTED OF A STOCK IS THE MARKET BETA
(FOR THIS REASON, CAPM IS CALLED A 1-FACTOR MODEL)
 THE CAPITAL ASSET
PRICING MODEL
CAPM
LIKE ANY RISK-RETURN MODEL, THE CAPM TAKES IN ASSET
CHARACTERISTICS, AND GIVES OUT AN EXPECTED RETURN

THE ONLY ASSET CHARACTERISTIC

THE CAPM CARES ABOUT IS
MARKET BETA
IF THE MARKET MOVES BY 1%, BY
HOW MUCH WILL A STOCK MOVE?
OF THE STOCK
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
= RISK-FREE +
RETURN OF
A STOCK RATE
MARKET BETA X EQUITY-RISK
OF THE STOCK PREMIUM
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM

THIS IS THE ONLY STOCK-SPECIFIC

PART OF THE CAPM FORMULA
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM

BETA IS, IN A SENSE, THE RISK (THE MARKET

RISK) ASSOCIATED WITH THE STOCK
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM

RISK-FREE RATE IS THE TYPICALLY THE YIELD ON A GOVERNMENT

SECURITY THAT HAS ZERO PROBABILITY OF DEFAULT

IN THE US, THIS WOULD TYPICALLY BE THE YIELD

ON A T-BILL OR A TREASURY BOND
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM
ERP
THIS IS A MEASURE OF THE EXCESS RETURN DEMANDED BY
STOCK INVESTORS OVER AND ABOVE THE RISK-FREE RATE
ESTIMATING THE ERP IS ALCHEMY, IN THE US
YOU CAN JUST USE ERP = 5%
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM
ERP
SINCE THIS IS A RISK-RETURN MODEL, THE
EXPECTED RETURN IS THE OUTPUT
 THE CAPITAL ASSET
PRICING MODEL
CAPM
EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN OF A
STOCK
= RATE
+ OF THE STOCK
X PREMIUM

LET’S ESTIMATE THE EXPECTED

RETURN ON GOOGLE, USING THE CAPM
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM
1.8909%
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM

1.8909%
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM
1.032
1.8909%
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM

1.8909% 1.032
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM

1.8909% 1.032 5%

LOTS OF ALCHEMY GOES INTO CALCULATING THE ERP, BUT

ITS MOSTLY AN ILLUSION OF ACCURACY. WE WILL JUST
USE 5% IN THIS CLASS
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= RATE
+ OF THE STOCK
X PREMIUM

1.8909% 1.032 5%
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED
RISK-FREE MARKET BETA EQUITY-RISK
RETURN
GOOGLE STOCK
= 1.8909%
RATE
+ 1.032
OF THE STOCK
X 5%
PREMIUM

7.05%
 LET’S ESTIMATE THE EXPECTED
RETURN ON GOOGLE, USING THE CAPM

EXPECTED RETURN
GOOGLE STOCK
= 7.05%

WE CAN NOW USE THIS TO DISCOUNT ANY FUTURE

UNCERTAIN CASH FLOWS FROM THE GOOGLE STOCK
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY
 RISK RETURN MODEL
RISK RETURN MODELS
MODEL

LET’S CHECK OUT A FEW EXAMPLES

RISKY EQUITY TOTAL VALUE OF A
DEBT (SHARES) OF A FIRM WITH BOTH
NO-DEBT FIRM DEBT AND EQUITY
 TOTAL VALUE OF A FIRM WITH BOTH DEBT AND EQUITY

ONCE AGAIN, FOR NOW, LET’S FOCUS

SOLELY ON THE DISCOUNT RATE TO USE

WE JUST FOUND THE DISCOUNT RATE TO USE FOR:

• A COMPANY’S DEBT
• A COMPANY’S EQUITY
 THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT
REMEMBER THAT THE FIRM ITSELF IS AN ASSET, JUST
LIKE A SINGLE STOCK OF THE FIRM, IS AN ASSET

THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A

WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT
 THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

DISCOUNT RATE ON THE EQUITY, WHICH WE JUST

FOUND USING CAPM
 THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

DISCOUNT RATE ON THE DEBT, WHICH WE FOUND FROM

THE CREDIT RATING AND THE MATURITY OF THE BOND
 THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

WHAT ARE THE WEIGHTS? THE PROPORTION OF DEBT AND

EQUITY IN THE CAPITAL STRUCTURE OF THE COMPANY!
 THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

WEIGHTED-AVERAGE COST OF CAPITAL

WACC
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
rd: DISCOUNT RATE FOR THE COMPANY’S DEBT
t: TAX RATE
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
EARNINGS ARE TAXED, WHILE DEBT SERVICING IS
TAX-DEDUCTIBLE.
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
re: DISCOUNT RATE FOR THE COMPANY’S EQUITY
(EG. CAPM EXPECTED RATE OF RETURN )
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
D: MARKET VALUE OF THE COMPANY’S DEBT
E: MARKET VALUE OF THE COMPANY’S EQUITY
D: MARKET VALUE OF THE COMPANY’S DEBT
E: MARKET VALUE OF THE COMPANY’S EQUITY
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
D: MARKET VALUE OF THE COMPANY’S DEBT E: MARKET VALUE OF THE COMPANY’S EQUITY
re,rd: DISCOUNT RATE FOR THE COMPANY’S EQUITY AND DEBT RESPECTIVELY

t: TAX RATE
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

THIS IS A VERY DEEP FORMULA, WITH A LOT

D x r x (1-t) + E
OF PROFOUND IMPLICATIONS
mkt d mkt x r e
wacc =
Dmkt + Emkt
BTW, IF YOU ARE WONDERING WHERE THIS FORMULA CAME FROM -
IT FOLLOWS
D: MARKET FROM
VALUE OF THE THE FAMOUS
COMPANY’S MODIGLIANI-MILLER
DEBT E: MARKET PROPOSITIONS
VALUE OF THE COMPANY’S EQUITY
re,rd: DISCOUNT RATE FOR THE COMPANY’S EQUITY AND DEBT RESPECTIVELY

t: TAX RATE
 BTW, IF YOU ARE WONDERING WHERE THIS FORMULA CAME FROM - IT FOLLOWS FROM THE FAMOUS MODIGLIANI-MILLER
PROPOSITIONS
PROPOSITION 1: A FIRM’S VALUE IS INDEPENDENT OF THE
MIX OF DEBT AND EQUITY IN IT’S CAPITAL STRUCTURE

PROPOSITION 2: THE MORE A FIRM BORROWS, THE

MORE RISKY ITS EQUITY GETS

(LOTS OF FINE PRINT OMITTED, BUT THIS IS THE ESSENCE:-))

BTW, IF YOU ARE WONDERING WHERE THIS FORMULA CAME FROM - IT FOLLOWS FROM THE FAMOUS MODIGLIANI-MILLER PROPOSITIONS

PROPOSITION 1: A FIRM’S VALUE IS INDEPENDENT OF THE MIX OF DEBT AND EQUITY IN IT’S CAPITAL
STRUCTURE

PROPOSITION 2: THE MORE A FIRM BORROWS, THE MORE RISKY ITS EQUITY GETS

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt

THE CHOICE OF MARKET PRICES OF EQUITY AND DEBT AS

WEIGHTS IN THE WACC FLOWS DIRECTLY FROM PROPOSITION 1
 Dmkt x rd x (1-t) + Emkt x re
wacc =
Dmkt + Emkt

THE CHOICE OF MARKET PRICES OF EQUITY AND DEBT AS WEIGHTS

WACC FLOWS DIRECTLY FROM PROPOSITION 1
IN THE

MARKET PRICE OF CAPITAL (EITHER DEBT OR EQUITY)

TELLS HOW MUCH CAN BE RAISED AT A CERTAIN COST

THIS WEIGHTING SCHEME IMPLIES THAT AS THE MIX OF DEBT

AND EQUITY CHANGES, WACC STAYS THE SAME

BTW, THE TAX RATE IS ACTUALLY QUITE SIGNIFICANT HERE

 Dmkt x rd x (1-t) + Emkt x re
wacc =
Dmkt + Emkt

BTW, THE TAX RATE IS ACTUALLY QUITE SIGNIFICANT HERE

re,rd: DISCOUNT RATE FOR THE COMPANY’S EQUITY AND DEBT RESPECTIVELY

NOW, INTEREST IS PAID OUT OF PRE-TAX INCOME, WHILE

DIVIDENDS ARE PAID OUT OF POST-TAX INCOME

SAY A FIRM HAS A DECISION: PAY $100 TO BONDHOLDERS,

OR $X TO SHAREHOLDERS.
LET’S SAY THE TAX RATE IS 33%
 NOW, INTEREST IS PAID OUT OF PRE-TAX INCOME, WHILE
DIVIDENDS ARE PAID OUT OF POST-TAX INCOME

SAY A FIRM HAS A DECISION: PAY $100 TO BONDHOLDERS,

OR $X TO SHAREHOLDERS.
LET’S SAY THE TAX RATE IS 33%

• IF THE FIRM DID NOT PAY OUT $100, IT WOULD HAVE TO

PAY TAXES ON THOSE $100

• ONLY $67 WOULD HIT THE COMPANY’S BOTTOM-LINE

SAY A FIRM HAS A DECISION: PAY
$100 TO
BONDHOLDERS, OR $X TO SHAREHOLDERS.
LET’S SAY THE TAX RATE IS 33%

THE VALUE OF X WHERE FIRM IS INDIFFERENT IS $67

PAYING $100 TO BONDHOLDERS IS EQUIVALENT TO

PAYING $67 TO SHAREHOLDERS
SAY A FIRM HAS A DECISION: PAY
$100 TO
BONDHOLDERS, OR $X TO SHAREHOLDERS
TO DO AN APPLES-TO-APPLES COMPARISON OF .
THE COST OF EQUITY AND THE COST OF DEBT LET’S SAY THE TAX RATE IS 33%

WE NEED TO REDUCE THE COST OF DEBT

THE VALUE OF X WHERE FIRM IS INDIFFERENT IS $67
BY THE TAX SAVING
PAYING $100
re,rd: DISCOUNT TOTHEBONDHOLDERS
RATE FOR IS EQUIVALENT
COMPANY’S EQUITY AND DEBT RESPECTIVELY TO
PAYING
t: TAX RATE $67 TO SHAREHOLDERS
TO DO AN APPLES-TO-APPLES COMPARISON OF THE
COST OF EQUITY AND THE COST OF DEBT

WE NEED TO REDUCE THE COST OF DEBT BY THE TAX SAVING

rd re
TO DO AN APPLES-TO-APPLES COMPARISON OF THE
COST OF EQUITY AND THE COST OF DEBT

WE NEED TO REDUCE THE COST OF DEBT BY THE TAX SAVING

re

rd
TO DO AN APPLES-TO-APPLES COMPARISON OF THE
COST OF EQUITY AND THE COST OF DEBT

WE NEED TO REDUCE THE COST OF DEBT BY THE TAX SAVING

re

rd x (1-t)
TO DO AN APPLES-TO-APPLES COMPARISON OF THE
COST OF EQUITY AND THE COST OF DEBT

WE NEED TO REDUCE THE COST OF DEBT BY THE TAX SAVING

rd x (1-t) re
 WEIGHTED-AVERAGE COST OF CAPITAL
THE DISCOUNT RATE FOR THE FIRM AS A WHOLE IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY AND THE COST OF DEBT

Dmkt x rd x (1-t) + Emkt x re

wacc =
Dmkt + Emkt
D: MARKET VALUE OF THE COMPANY’S DEBT E: MARKET VALUE OF THE COMPANY’S EQUITY
re,rd: DISCOUNT RATE FOR THE COMPANY’S EQUITY AND DEBT RESPECTIVELY

t: TAX RATE
 WEIGHTED-AVERAGE COST OF CAPITAL
IMPORTANT:
THE DISCOUNTUSE
RATETHE
FOR WACC
THE FIRM FOR
AS AALL CASH
WHOLE FLOWS
IS SIMPLY A
WEIGHTED AVERAGE OF THE COST OF EQUITY
AND ALL PROJECTS ASSOCIATED WITH THE FIRM AND THE COST OF DEBT

FOR INSTANCE, DO NOT USE COST-OF-DEBT

Dmkt x rd x (1-t) + Emkt x re TO EVALUATE
NPV OF A DEBT-FUNDED PROJECT
wacc =
D mkt + E mkt
THAT’S BECAUSE THE FUNDING OF A SPECIFIC PROJECT HAS OPPORTUNITY
COSTS, AND IS TIED TO THE OVERALL COST OF FUNDING OF THE
D: MARKET VALUE OF THE COMPANY’S DEBT E: MARKET VALUE OF THE COMPANY’S EQUITY FIRM
re,rd: DISCOUNT RATE FOR THE COMPANY’S EQUITY AND DEBT RESPECTIVELY

t: TAX RATE
IMPORTANT: USE THE WACC FOR ALL CASH FLOWS
AND ALL PROJECTS ASSOCIATED WITH THE FIRM

ERRM..
WHAT ABOUT NEGATIVE CASH FLOWS? ARE WE NOT DISTORTING
THEM BY DISCOUNTING WITH HIGHER RATES FOR HIGHER RISK?

EXCELLENT POINT! YES WE ARE. BUT STICKING TO THE

WACC IS STILL THE BEST OF A MENU OF BAD CHOICES HERE
 Dmkt x rd x (1-t) + Emkt x re
wacc =
Dmkt + Emkt

MARKET BETA
OR TOTAL BETA?
WHAT
CONSTITUTES DEBT?
MARKET PRICE
OF DEBT?
 Dmkt x rd x (1-t) + Emkt x re
wacc =
Dmkt + Emkt

MARKET BETA
OR TOTAL BETA?
WHAT
CONSTITUTES DEBT?
MARKET PRICE
OF DEBT?
 MARKET BETA OR TOTAL BETA?

EXPECTED
= RISK-FREE +
RETURN OF
A STOCK RATE
MARKET BETA X EQUITY-RISK
OF THE STOCK PREMIUM
BUT ACTUALLY, WE SHOULD USE THE TOTAL BETA, NOT
THE MARKET BETA, WHILE CALCULATING THE WACC
 MARKET BETA OR TOTAL BETA?
BUT ACTUALLY, WE SHOULD USE THE TOTAL BETA, NOT THE MARKET BETA,
WHILE CALCULATING THE WACC