Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

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Thecostofequityistherateofreturnthatinvestorsrequireto
makeanequityinvestmentinafirm.Alloftheriskandreturn
models described in the preceding section need a risk-free rate
andariskpremium(intheCAPM)orpremiums(intheAPM
andmultifactormodels).Wewillbeginbydiscussingthose
commoninputsbeforeweturnourattentiontotheestimation
of betas.


Risk-Free Rate


Mostriskandreturnmodelsinfinancestartoffwithanasset
thatisdefinedasriskfreeandusetheexpectedreturnonthat
asset as the risk-free rate. The expected returns on risky
investmentsarethenmeasuredrelativetotherisk-freerate,
withtheriskcreatinganexpectedriskpremiumthatisadded
on to the risk-free rate.


Determining a Risk-Free Rate


Wedefinedarisk-freeassetasonewheretheinvestorknows
the expected return with certainty. Consequently, for an
investmenttobe riskfree(i.e.,to havean actualreturnbe
equal to the expected return), two conditions have to be met:


1.Therecanbenodefaultrisk,whichgenerallyimpliesthat
thesecurityhastobeissuedbyagovernment.Note,though,
thatnotallgovernmentsaredefaultfreeandthepresenceof
government or sovereign default risk can make it very
difficult to estimate risk-free rates in some currencies.



  1. There can be no uncertainty about reinvestment rates,
    whichimpliesthattherearenointermediatecashflows.To
    illustratethispoint,assumethatyouaretryingtoestimatethe

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