Thursday, November 13

Valuing risky Real Assets

There are basically two methods for computing the market values of the future cash flows of risky investment projects - Certainty Equivalent Approach and Risk Adjusted Discount Rate (RADR) method.

The RADR method obtains the discount rates from widely used theories of risk and return such as Capital Asset Pricing Model (CAPM) and is thus impractical when Betas of comparison firms are difficult to estimate. In such cases where comparison firms do not exist and risk is required to be estimated, practical considerations suggest that Certainty Equivalent Method is a better valuation tool.

The Present Value formula under Certainty Equivalent Method is given by:

PV = SUM(Expected Future Cash Flows) - Beta (Risk of Tangency portfolio - Risk Free Rate)
                                                         (1+ Risk Free Rate)


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