Corporate Finance

In the last chapter, we presented the argument that the expected return on an

equity investment should be a function of the market or non-diversifiable embedded in

that investment. In this chapter, we turn our attention to how best to estimate the

parameters of market risk in each of the models described in the previous chapter - the

capital asset pricing model, the arbitrage pricing model and the mutli-factor model. We

will present three alternative approaches for measuring the market risk in an investment;

the first is to use historical data on market prices for the firm considering the project, the

second is to use the market risk parameters estimated for other firms that are in the same

business as the project being analyzed and the third is to use accounting earnings or

revenues to estimate the parameters.

In addition to estimating market risk, we will also discuss how best to estimate a

riskless rate and a risk premium (in the CAPM) or risk premiums (in the APM and multifactor

models) to convert the risk measures into expected returns. We will present a

similar argument for converting default risk into a cost of debt, and then bring the

discussion to fruition by combining both the cost of equity and debt to estimate a cost of

capital, which will become the minimum acceptable hurdle rate for an investment.Cash Flows and Risk free Rates: The Consistency Principle

The risk free rate used to come up with expected returns should be measured

consistently with how the cash flows are measured. If the cashflows are nominal, the

riskfree rate should be in the same currency in which the cashflows are estimated. This

also implies that it is not where a project or firm is domiciled that determines the choice

of a risk free rate, but the currency in which the cash flows on the project or firm are

estimated. Thus, Disney can analyze a proposed project in Mexico in dollars, using a

dollar