Uncertainty Default and Risk

Promised vs. Expected Returns; Debt vs. Equity

You will now enter the world of uncertainty—though we shall still pretend that you live in a perfect market with no taxes, no transaction costs, no differences of opinion, and infinitely many investors and firms.

Net present value still rules, but you will now have to face the sad fact that it is no longer easy to use. It is not the NPV concept that is difficult. Instead, it is the inputs—the expected cash flows and appropriate costs of capital—that can be so very difficult to estimate in the real world.

In a world of uncertainty, there will be scenarios in which you will get more cash than you expected and scenarios in which you will get less. The single most important insight is that you must then always draw a sharp distinction between promised (or quoted) returns and expected returns. Because firms can default on payments or go bankrupt in the future, promised returns are higher than expected returns.

After setting forth the necessary statistical background, this chapter will cover two important topics: First, you get to determine how lenders should charge borrowers if there is the possibility of default. Second, you learn how to work with the two important building blocks of financing, namely, debt and equity.

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