CHAPTER 2
Estimating Discount Rates
Indiscountedcash flowvaluations, thediscountratesused
shouldreflecttheriskinessofthecashflows.Inparticular,the
costofdebthastoincorporateadefaultpremiumorspread
forthedefaultriskinthedebt,andthecostofequityhasto
include a risk premium for equity risk. But how do we
measuredefaultandequityrisk,andmoreimportantly,how
do we come up with the default and equity risk premiums?
Inthischapter,welaythefoundationsforanalyzingriskin
valuation.Wepresentalternativemodelsformeasuringrisk
and converting these risk measures into acceptable hurdle
rates.Webeginwithadiscussionofequityriskandexamine
thedistinctionbetweendiversifiableandnondiversifiablerisk
andwhyonlythelattermatterstoadiversifiedinvestor.We
alsolookathowdifferentriskandreturnmodelsinfinance
attempttomeasurethis nondiversifiablerisk.Inthesecond
partofthischapter, weconsiderdefaultriskand howitis
measured by ratings agencies. In addition, we discuss the
determinantsofthedefaultspreadandwhythedefaultspread
mightchangeovertime.Finally,wewillbringthediscussion
tofruitionbycombining thecostofequityandthecost of
debt to estimate a cost of capital.
WHAT IS RISK?
Risk, formost of us,refers to thelikelihoodthat in life’s
gamesofchance,wewillreceiveoutcomesthatwewillnot
like.Forinstance,theriskofdrivingacartoofastisgettinga