thegreaterthevariation,thegreatertherisk.Whenlookingat
equity, we tend to use measures of risk based on return
variance.Thenextchapterlooksatthedifferentmodelsthat
attempttodothisinfarmoredetail,buttherearesomebasic
pointsonwhichthesemodelsagree.Thefirstisthatriskinan
investment has to be perceived through the eyes of the
marginalinvestorinthatinvestment(theinvestormostlikely
to betrading),and thismarginalinvestorisassumed tobe
welldiversified acrossmultipleinvestments. Therefore, the
riskinaninvestmentthatshoulddeterminediscountratesis
thenondiversifiableor market riskofthat investment.The
secondisthattheexpectedreturnonanyinvestmentcanbe
obtained starting with the expected return on a riskless
investment,andaddingtoitapremiumtoreflecttheamount
ofmarketriskinthatinvestment.Thisexpectedreturnyields
the cost of equity.
Thecostofcapitalcanbeobtainedbytakinganaverageof
the cost of equity, estimated as just described, and the
after-tax cost of borrowing, based on default risk, and
weightingbytheproportionsusedofeach.Wearguethatthe
weightsused,whenvaluinganongoingbusiness,shouldbe
basedonthemarketvaluesofdebtandequity.While there
are some analysts who use book value weights, doing so
violatesabasicprincipleofvaluation,whichisthatatafair
value,
3 one shouldbe indifferentbetweenbuying and sellingan
asset.
Expected Cash Flows
Inthestrictestsense,theonly cashflowanequityinvestor
getsoutofapubliclytradedfirmisthedividend;modelsthat