Last Study Topics

Value Vs Growth Stock

Standard vs Consumption CAPM
Asset Pricing Model
Three Factor Model

Todays Study Topics

Understanding of Statements
Qualification of Statements
Numerical

True or false?
Explain or qualify as necessary.
a. Investors demand higher
expected rates of return on
stocks with more variable rates
of return.

True or false?
Explain or qualify as necessary.
a. Investors demand higher
expected rates of return on
stocks with more variable rates
of return.
False investors demand higher
expected rates of return on stocks with
more non-diversifiable risk.

Continue
b. The CAPM predicts that a
security with a beta of 0 will
offer a zero expected return.

Continue
b. The CAPM predicts that a
security with a beta of 0 will
offer a zero expected return.
False a security with a beta of zero will
offer the risk-free rate of return.

Continue
c. An investor who puts $10,000
in Treasury bills and $20,000 in
the market portfolio will have a
beta of 2.0.

Continue
c. An investor who puts $10,000
in Treasury bills and $20,000 in
the market portfolio will have a
beta of 2.0.
False the beta will be:

(1/3)(0) + (2/3)(1) = 0.67

X & Y Shares
Mark Harrywitz proposes to invest in
two shares, X and Y. He expects a
return of 12% from X and 8% from Y.
The standard deviation of returns is
8% for X and 5% for Y. The correlation
coefficient between the returns is .2.
a. Compute the expected return and
standard deviation of the portfolios
given on the next slide:

Continue
Portfolios
PORTFOL % IN X
IO

% IN Y

50

50

25

75

75

25

Solutions:
PORTFO
LIO

Mean (r)

S.D

10%

5.1%

9.0%

4.6%

11.0%

6.4%

Graph

Solution:
The set of
portfolios is
represented by the
curved line. The
five points are the
three portfolios
from Part (a) plus
the two following
two portfolios:
-One consists of
100% invested in X
and the other
consists of 100%
invested in Y.

b. Sketch the set of

portfolios composed
of X and Y.

Shares Investment
Example: M. Grandet has invested 60
percent of his money in share A and
the remainder in share B. He
assesses their prospects as follows:
A

Expected Return %

15

20

Standard Deviation
%

20

22

Correlation

.5

.5

Continue
a. What are the expected return
and standard deviation of
returns on his portfolio?
Expected return = (0.6 15) + (0.4
20) = 17%
Variance = (0.6)2 (20)2 + (0.4)2 (22)2
+ 2(0.6)(0.4)(0.5)(20)(22) =
327
Standard deviation = (327)(1/2) = 18.1%

Continue
b. How would your answer
change if the correlation
coefficient was 0 or .5?

Continue
b. How would your answer
change if the correlation
coefficient was 0 or .5?
Correlation coefficient = 0 Standard
deviation = 14.9%
Correlation coefficient = -0.5 Standard
deviation = 10.8%

Continue
c. Is M. Grandets portfolio
better or worse than one
invested entirely in share A, or is
it not possible to say?
His portfolio is better. The portfolio has a
higher expected return and a lower
standard deviation.

Case: Percival Hygiene

Percival Hygiene has $10 million invested
in long-term corporate bonds. This bond
portfolios expected annual rate of return
is 9%, and the annual standard deviation
is 10%.
Amanda Reckonwith, Percivals financial
adviser, recommends that Percival
consider investing in an index fund which
closely tracks the Standard and Poors 500
index. The index has an expected return
of 14%, and its standard deviation is 16%.

Required (a)
a. Suppose Percival puts all his
money in a combination of the
index fund and Treasury bills.
Can he thereby improve his expected
rate of return without changing the risk
of his portfolio? The Treasury bill yield is
6%.

Understanding
Percivals current portfolio provides
an expected return of 9% with an
annual standard deviation of 10%.
First we find the portfolio weights for
a combination of Treasury bills
(security 1: standard deviation = 0%)
and the index fund (security 2:
standard deviation = 16%) such that
portfolio standard deviation is 10%.

Continue
In general, for a two security portfolio:

Further:

Therefore, he can improve his expected rate

of return without changing the risk of his
portfolio.

Summary
Understanding of Statements
Qualification of Statements
Numerical

Continue
b. Could Percival do even better
by investing equal amounts in
the corporate bond portfolio and
the index fund?
The correlation between the bond
portfolio and the index fund is +0.1.
rp = x1r1 + x2r2
rp = (0.5 0.09) + (0.5 0.14) = 0.115
= 11.5%

Continue
P2 = x1212 + 2x1x21212 + x2222
P 2 = (0.5)2(0.10)2 + 2(0.5)(0.5)(0.10)
(0.16)(0.10) + (0.5)2(0.16)2
P2 = 0.0097
P = 0.985 = 9.85%

Understanding
Therefore, he can do even better by
investing equal amounts in the
corporate bond portfolio and the
index fund.
His expected return increases to
11.5% and the standard deviation of
his portfolio decreases to 9.85%.

Explain
There may be some truth in these CAPM
and APT theories, but last year some
stocks did much better than these
theories predicted, and other stocks did
much worse. Is this a valid criticism?
No. Every stock has unique risk in addition to
market risk. The unique risk reflects
uncertain events that are unrelated to the
return on the market portfolio. The Capital
Asset Pricing Model does not predict these
events.

Explain
a. The APT factors cannot reflect
diversifiable risks.
True. By definition, the factors represent
macro-economic risks that cannot be
eliminated by diversification.

b. The market rate of return

cannot be an APT factor.
False. The APT does not specify the factors.

Continue
c. Each APT factor must have a
positive risk premium associated
with it; otherwise the model is
inconsistent.
True. Investors will not take on nondiversifiable risk unless it entails a
positive risk premium.

Continue
d. There is no theory that
specifically identifies the APT
factors.
True. Different researchers have
proposed and empirically investigated
different factors, but there is no widely
accepted theory as to what these
factors should be.

Continue
e. The APT model could be true but
not very useful, for example, if the
relevant factors change
unpredictably.
True. To be useful, we must be able to
estimate the relevant parameters.
If this is impossible, for whatever reason, the
model itself will be of theoretical interest
only.

APT Model
Consider the following simplified APT
model:
FACTOR
EXPECTED RISK
PREMIUM
Market

6.4%

Interest rate

-0.6%

Yield Spread

5.1%

Factor
Risk
Exposures
MARKET
INTEREST
YIELD
RATE

SPREAD

STOCK

(b1)

(b2)

(b3)

1.0

-2.0

-0.2

P2

1.2

.3

P3

.3

.5

1.0

Continue
a. Calculate the expected return
for the following stocks. Assume
rf = 5%.
For Stock P r = (1.0)(6.4%) + (-2.0)(0.6%) + (-0.2)(5.1%) = 6.58%
For Stock P2 r = (1.2)(6.4%) + (0)(0.6%) + (0.3)(5.1%) = 9.21%
For Stock P3 r = (0.3)(6.4%) +
(0.5)(-0.6%) + (1.0)(5.1%) = 6.72%

Continue
b. What are the factor risk
exposures for the portfolio?
Factor risk exposures:

b1(Market) = (1/3)(1.0) + (1/3)(1.2) +

(1/3)(0.3) = 0.83
b2(Interest rate) = (1/3)(-2.0)
+(1/3)(0) + (1/3)(0.5) = -0.50
b3(Yield spread) = (1/3)(-0.2) +
(1/3)(0.3) + (1/3)(1.0) = 0.37

Continue
b. What is the portfolios
expected return?
rP = (0.83)(6.4%) + (-0.50)(-0.6%)
+ (0.37)(5.1%) = 7.5%

Three Factors Model

The following table shows the sensitivity
of four stocks to the three FamaFrench
factors in the five years to 2001.
Estimate the expected return on each
stock assuming that the interest rate is
3.5%, the expected risk premium on the
market is 8.8%, the expected risk
premium on the size factor is 3.1%, and
the expected risk premium on the bookto-market factor is 4.4%.

Continue
Factor
Sensitivitie
s

FACTOR

COCA-COLA

EXXON
MOBILE

PFIZER

REEBOK

Market

.82

.50

.66

1.17

Size

-0.29

.04

-.56

.73

Book-toMarket

.24

.27

-.07

1.14

rCoca-Cola = 3.5% + (0.82 8.8%) + (-0.29 3.1%)

+ (0.24 4.4%) = 10.87%
rEXXON= 3.5% + (0.50 8.8%) + (0.04 3.1%) +
(0.27 4.4%) = 9.21%

Continue
rPFizer = 3.5% + (0.66 8.8%) + (0.56 3.1%) + (-0.07 4.4%) =
7.26%
rReebok = 3.5% + (1.17 8.8%) +
(0.73 3.1%) + (1.14 4.4%) =
21.08%

Principles of
Corporate
Finance
Sixth Edition

Richard A. Brealey
Stewart C. Myers

McGraw Hill/Irwin

Chapter 9
Capital Budgeting and
Risk

Topics Covered

Company and Project Costs of Capital

Measuring the Cost of Equity
Capital Structure and COC
Discount Rates for Intl. Projects
Estimating Discount Rates
Risk and DCF

Introduction
LONG BEFORE THE development of
modern theories linking risk and
expected return, smart financial
managers adjusted for risk in capital
budgeting.
How they should treat the element of
risk with respect to each and every
projects of different class?

Continue
Various rules of thumb are often used
to make these risk adjustments.
For example, many companies estimate
the rate of return required by investors
in their securities and then use this
company cost of capital to discount the
cash flows on new projects.

COMPANY AND PROJECT COSTS

OF CAPITAL
The company cost of capital is
defined as the expected return on a
portfolio of all the companys existing
securities.
It is used to discount the cash flows
on projects that have similar risk to
that of the firm as a whole.

Continue
We estimated that investors require a return
of 9.2% from Pfizer common stock.
If Pfizer is contemplating an expansion of
the firms existing business, it would make
sense to discount the forecasted cash flows
at 9.2 %.
The company cost of capital is not the
correct discount rate if the new projects are
more or less risky than the firms existing
business..

Company Cost of Capital

A firms value can be stated as the
sum of the value of its various
assets.
Each project should in principle be
evaluated at its own opportunity cost
of capital.
For a firm composed of assets A and
Firm
value

PV(AB)

PV(A)

PV(B)
B, the firm value is;

Continue
Here PV(A) and PV(B) are valued just
as if they were mini-firms in which
stockholders could invest directly.
Investors would value A by
discounting its forecasted cash flows
at a rate reflecting the risk of A.
They would value B by discounting at
a rate reflecting the risk of B.
The two discount rates will, in general, be
different.

Continue
This means that Pfizer should accept any
project that more than compensates for
the projects beta.
In other words, Pfizer should accept any
project lying above the upward-sloping
line that links expected return to risk in
Figure 1.
If the project has a high risk, Pfizer needs a
higher prospective return than if the project
has a low risk.

Company Cost of Capital

A companys cost of capital can be
compared to the CAPM required return
SML

Required
return

13
Company Cost
of Capital

5.5
0
1.26

Project Beta

Understanding
In terms of Figure1, the rule tells
Pfizer to accept any project above
the horizontal cost of capital line,
that is, any project offering a return
of more than 9.2%.
The company cost of capital rule, which
is to accept any project regardless of its
risk as long as it offers a higher return
than the companys cost of capital.

Understanding
It is clearly silly to suggest that Pfizer should
demand the same rate of return from a very
safe project as from a very risky one.
If Pfizer used the company cost of capital
rule, it would reject many good low-risk
projects and accept many poor high-risk
projects.
Many firms require different returns from
different categories of investment.

Understanding
For example, discount rates might be
set as follows:
Category

Discount Rate

Speculative ventures
New products

30%
20%

Expansion of existing business

15% (Company COC)

Cost improvement, known technology

10%

Perfect Pitch and the Cost of

Capital

The true cost of capital depends on

project risk, not on the company
undertaking the project.

So why is so much time spent estimating

the company cost of capital?

First, many (maybe, most) projects

can be treated as average risk, that is,
no more or less risky than the average
of the companys other assets.
For these projects the company cost of
capital is the right discount rate.

Continue
Second, the company cost of capital is
a useful starting point for setting
discount rates for unusually risky or
safe projects.
It is easier to add to, or subtract from, the
company cost of capital than to estimate
each projects cost of capital from scratch.
Anyone who can carry a tune gets relative
pitches right.

Business People
are used to, but not about absolute
risk or required rates of return.
Therefore, they set a companywide
cost of capital as a benchmark.
This is not the right hurdle rate for
everything the company does.
But adjustments can be made for more
or less risky ventures.

MEASURING THE COST OF

EQUITY
Suppose that you are considering an acrossthe-board expansion by your firm.
Such an investment would have about the
same degree of risk as the existing business.
Therefore you should discount the projected
flows at the company cost of capital.
Companies generally start by estimating the
return that investors require from the
companys common stock.

Continue
Used the capital asset pricing model
to do the working. This states;
Expected stock return =rf + Beta(rm rf)

An obvious way to measure the beta

(B) of a stock is to look at how its
price has responded in the past to
market movements.

Measuring Betas
The SML shows the relationship
between return and risk.
CAPM uses Beta as a proxy for risk.
Other methods can be employed to
determine the slope of the SML and
thus Beta.
Regression analysis can be used to
find Beta.

Dell Computer Stock

Calculated monthly returns from Dell
Computer stock in the period, after it went
public in 1988, is given on the next slide.
Also plotted returns against the market
returns for the same month, is given too.
We have fitted a line through the points.
The slope of this line is an estimate of beta.

Measuring Betas
Dell Computer

Dell return (%)

Price data Aug 88- Jan 95

R2 = .11
B = 1.62

Slope determined from

plotting the line of best fit.

Market return (%)

Measuring Betas
Dell Computer

Dell return (%)

Price data Feb 95 Jul 01

R2 = .27
B = 2.02

Slope determined from

plotting the line of best fit.

Market return (%)

Other Stocks
The next diagram shows a similar plot for the
returns on General Motors stock, and the
Third shows a plot for Exxon Mobil.
In each case we have fitted a line through
the points.
The slope of this line is an estimate of beta.
It tells us how much on average the stock price
changed for each additional 1% change in the
market index.

Measuring Betas
General Motors

GM return (%)

Price data Aug 88- Jan 95

R2 = .13
B = 0.80

Slope determined from

plotting the line of best fit.

Market return (%)

Measuring Betas
General Motors

GM return (%)

Price data Feb 95 Jul 01

R2 = .25
B = 1.00

Slope determined from

plotting the line of best fit.

Market return (%)

Measuring Betas
Exxon Mobil

Exxon Mobil return (%)

Price data Aug 88- Jan 95

R2 = .28
B = 0.52

Slope determined from

plotting the line of best fit.

Market return (%)

Measuring Betas
Exxon Mobil

Exxon Mobil return (%)

Price data Feb 95 Jul 01

R2 = .16
B = 0.42

Slope determined from

plotting the line of best fit.

Market return (%)

Understanding
Diagrams show plots for the three
stocks during the subsequent period,
February 1995 to July 2001.
Although the slopes varied from the
first period to the second, there is little
doubt that Exxon Mobils beta is much
less than Dells or that GMs beta falls
somewhere between the two.
If you had used the past beta of each
stock to predict its future beta, you
wouldnt have been too far off.

Understanding
Only a small portion of each stocks
total risk comes from movements in the
market.
The rest is unique risk, which shows up
in the scatter of points around the fitted
lines in Diagrams.
R-squared (R2) measures the proportion of
the total variance in the stocks returns that
can be explained by market movements.

Table 1
Estimated betas and costs of (equity) capital for a sample of large railroad
companies and for a portfolio of these companies. The precision of the
portfolio beta is much better than that of the betas of the individual
companiesnote the lower standard error for the portfolio.

The Expected Return on Union Pacific

Corporations Common Stock
Suppose that in mid-2001 you had been
asked to estimate the company cost of
capital of Union Pacific Corporation.
Table 1 provides two clues about the
true beta
of Union Pacifics stock:
The direct estimate of .40 and the average
estimate for the industry of .50.
Use the industry average of .50

Continue
In mid-2001 the risk-free rate of interest
rf was about 3.5%.
8% for the risk premium on the market,
You would have concluded that the
expected return on Union Pacifics stock
was about 7.5%.
Expected stock return= rf +Beta(rm rf)
= 3.5 + .5(8.0)
= 7.5%

CAPITAL STRUCTURE AND THE

COMPANY COST OF CAPITAL
we need to look at the relationship
between the cost of capital and the mix of
debt and equity used to finance the
company.
Think again of what the company cost of
capital is and what it is used for.
We define it as the opportunity cost of
capital for the firms existing assets;
we use it to value new assets that have the
same risk as the old ones.

Company Cost of Capital

simple approach

Company Cost of Capital (COC) is

based on the average beta of the
assets
The average Beta of the assets is
based on the % of funds in each
asset

Company Cost of Capital

simple approach
Company Cost of Capital (COC) is based on the
average beta of the assets
The average Beta of the assets is based on the % of
funds in each asset
Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6
AVG B of assets = 1.3

Capital Structure
Capital Structure - the mix of debt & equity within a
company
Expand CAPM to include CS

R = r f + B ( r m - rf )
becomes

Requity = rf + B ( rm - rf )

Capital Structure & COC

COC = rportfolio = rassets
rassets = WACC = rdebt

(D) + requity (E)

(V)

(V)
Bassets = Bdebt (D) + Bequity (E)
requity = rf + Bequity ( rm - rf )

(V)

(V)

Union Pacific Corp.

Example

Assets
Total Assets

Rassets
Rassets

100

Debt value
Equity value
Firm value

30
70
100

debt
equity

rdebt
requity
debt equity
debt equity
30
70

7.5%
15% 12.75%
30 70
30 70

Understanding
If the firm is contemplating investment
in a project that has the same risk as
the firms existing business, the
opportunity cost of capital for this
project is the same as the firms cost of
capital; in other words, it is 12.75
percent.
What would happen if the firm issued an
additional 10 of debt and used the cash to
repurchase 10 of its equity?

Union Pacific Corp.

Example

Assets
Total Assets

Rassets
Rassets

100

Debt value
Equity value
Firm value

40
60
100

debt
equity

rdebt
requity
debt equity
debt equity
40
60

7.875%
15% 12.75%
40 60
40 60

Understanding
The change in financial structure does
not affect the amount or risk of the
cash flows on the total package of
debt and equity.
Therefore, if investors required a
return of 12.75% on the total package
before the refinancing, they must
require a 12.75% return on the firms
assets afterward.

Solve for Equity

Since the company has more debt
than before, the debt holders are
likely to demand a higher interest
rate.
We will suppose that the expected
return on the debt rises to 7.875%.
Now you can write down the basic
equation for the return on assets and
solve for return on Equity. i.e.

Continue
Rassets

debt
equity

rdebt
requity
debt equity
debt equity

Return on equity = 16%

Increasing the amount of debt increased debtholder risk
and led to a rise in the return that debtholders required
(rdebt rose from 7.5 to 7.875%). The higher leverage also
made the equity riskier and increased the return that
shareholders required (requity rose from 15 to 16 %).

Continue
The weighted average return on debt
and equity remained at 12.75 percent:

What happen to cost of capital and

return on equity,
If Co. has paid all of its debt and replace
it with equity?

How Changing Capital

Structure Affects Beta
The stockholders and debtholders both
receive a share of the firms cash flows,
and both bear part of the risk.
For example, if the firms assets turn out to
be worthless, there will be no cash to pay
stockholders or debtholders.

But debtholders usually bear much less

risk than stockholders. Debt betas of
large blue-chip firms are typically in the
range of .1 to .3.

Continue
The firms asset beta is equal to the beta of
a portfolio of all the firms debt and its
equity.
The beta of this hypothetical portfolio is just
a weighted average of the debt and equity
betas:
debt
equity
Bassets
Bdebt
Bequity
debt equity
debt equity

Continue
If the debt before the refinancing has a
beta of .1 and the equity has a beta of
1.1, then;
Beta assets = .8
Bassets

debt
equity

Bdebt
Bequity
debt equity
debt equity

Continue
What happens after the refinancing? The risk of
the total package is unaffected, but both the debt
and the equity are now more risky.
Suppose that the debt beta increases to 0.2.
Beta Equity = 1.2

Bassets

debt
equity

Bdebt
Bequity
debt equity
debt equity

Understanding
Financial leverage does not affect the risk or
the expected return on the firms assets,
but it does push up the risk of the common
stock.
Shareholders demand a correspondingly
higher return because of this financial risk.
Figure on the next slide shows the expected
return and beta of the firms assets.
It also shows how expected return and risk are
shared between the debtholders and equity
holders before the refinancing.

Capital Structure & COC

Expected Returns and Betas prior to
refinancing

Expecte
d return
(%)
Requity=15

Rassets=12.
75
Rrdebt=7.5

Bdebt

Bassets

Bequity

Capital Structure & COC

Expected Returns and Betas prior to
refinancing

Expecte
d return
(%)
Requity=16

Rassets=12
.75
Rrdebt=7.8
75

Bdebt

Bassets

Bequity

Summary

Union Pacific Corp.

Requity = Return on Stock
= 15%
Rdebt = YTM on bonds
= 7.5 %

Union Pacific Corp.

Beta Standard. Error

Burlington Northern .64
.20
CSX Transporta tion
Norfolk Southern
Union Pacific

.46
.52
.40

.24
.26
.21

Industry Portfolio

.50

.17

International Risk
Correlation
Ratio
Beta
coefficient
Egypt
3.11
.18
0.55
Poland
1.93
.42
0.81
Thailand
2.91
.48
1.39
Venezuela
2.58
.30
0.77
Source: The Brattle Group, Inc.

Ratio - Ratio of standard deviations, country index vs.

S&P composite index

Asset Betas
PV(fixed
cost)
PV(fixed
cost)
BBrevenue BBfixed cost
revenue
fixed cost PV(revenue )
PV(revenue)
PV(variabl
eecost)
PV(asset)
PV(variabl
cost)
BBvariable cost
BBasset PV(asset)
variable cost
asset PV(revenue )
PV(revenue
)
PV(revenue)
PV(revenue)

Asset Betas
PV(revenue
))--PV(variabl
eecost)
PV(revenue
PV(variabl
cost)
BBasset BBrevenue
asset
revenue
PV(asset)
PV(asset)

PV(fixed
cost)
PV(fixed
cost)
BBrevenue 11

revenue
PV(asset)

PV(asset)

Risk,DCF and CEQ

Ct
CEQt
PV

t
t
(1 r )
(1 rf )

Risk,DCF and CEQ

Example
Project A is expected to produce CF =
$100 mil for each of three years. Given a
risk free rate of 6%, a market premium of
8%, and beta of .75, what is the PV of the
project?

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?

r rf B ( rm rf )
6 .75(8)
12%

r
(62%

r.758mf)
B
f1

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?

Year

Project A
Cash Flow PV @ 12%

100

89.3

2
3

100
100

79.7
71.2

Total PV

240.2

r
(62%

r.758mf)
B
f1

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?
Project A

Year

Cash Flow PV @ 12%

1
2

100
100

89.3
79.7

100
Total PV

71.2
240.2

Now assume that

the cash flows
change, but are
RISK FREE. What is
the new PV?

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?.. Now assume that the
cash flows change, but are RISK FREE. What is the new PV?

Year
1
2
3

Project A
Cash Flow PV @ 12%
100
89.3
100
79.7
100
71.2
Total PV
240.2

Year

Project B
Cash Flow PV @ 6%

94.6

89.3

2
3

89.6
84.8

79.7
71.2

Total PV

240.2

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?.. Now assume that the
cash flows change, but are RISK FREE. What is the new PV?

Year
1
2
3

Project A
Cash Flow PV @ 12%
100
89.3
100
79.7
100
71.2
Total PV
240.2

Year
1
2
3

Project B
Cash Flow PV @ 6%
94.6
89.3
89.6
79.7
84.8
71.2
Total PV
240.2

Since the 94.6 is risk free, we call it a Certainty Equivalent of

the 100.

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium of
8%, and beta of .75, what is the PV of the project?
DEDUCTION FOR RISK

Year
1
2
3

Deduction
Cash Flow CEQ
for risk
100
94.6
5.4
100
89.6
10.4
100
84.8
15.2

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?.. Now assume that the
cash flows change, but are RISK FREE. What is the new PV?

The difference between the 100 and the certainty equivalent

(94.6) is 5.4%this % can be considered the annual premium on
a risky cash flow

Risky cash flow

certainty equivalent cash flow
1.054

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and
beta of .75, what is the PV of the project?.. Now assume that the
cash flows change, but are RISK FREE. What is the new PV?

100
Year 1
94.6
1.054
Year 2

100
89.6
2
1.054

100
Year 3
84.8
3
1.054