Risk Measurement And Hurdle Rates

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 multi-factor 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.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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