The Investment Principle: Estimating Hurdle Rates,“You cannot swing upon a rope that is attached only to your own belt.”,First Principles,Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics.,Inputs required to use the CAPM -,The capital asset pricing model yields the following expected return: Expected Return = Riskfree Rate+ Beta * (Expected Return on the Market Portfolio - Riskfree Rate) To use the model we need three inputs: The current risk-free rate (b) The expected market risk premium (the premium expected for investing in risky assets (market portfolio) over the riskless asset) (c) The beta of the asset being analyzed.,The Riskfree Rate and Time Horizon,On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be riskfree, i.e., to have an actual return be equal to the expected return, two conditions have to be met There has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free. There can be no uncertainty about reinvestment rates, which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed.,Riskfree Rate in Practice,The riskfree rate is the rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed. Theoretically, this translates into using different riskfree rates for each cash flow - the 1 year zero coupon rate for the cash flow in year 1, the 2-year zero coupon rate for the cash flow in year 2 . Practically speaking, if there is substantial uncertainty about expected cash flows, the present value effect of using time varying riskfree rates is small enough that it may not be worth it.,The Bottom Line on Riskfree Rates,Using a long term government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value. For short term analysis, it is entirely appropriate to use a short term government security rate as the riskfree rate. The riskfree rate that you use in an analysis should be in the same currency that your cashflows are estimated in. In other words, if your cashflows are in U.S. dollars, your riskfree rate has to be in U.S. dollars as well. If your cash flows are in Euros, your riskfree rate should be a Euro riskfree rate.,What if there is no default-free entity?,You could adjust the local currency government borrowing rate by the estimated default spread on the bond to arrive at a riskless local currency rate. The default spread on the government bond can be estimated using the local currency ratings that are available for many countries. For instance, assume that the Mexican 10-year peso bond has an interest rate of 8.85% and that the local currency rating assigned to the Mexican government is AA. If the default spread for AA rated bonds is 0.7%, the riskless nominal peso rate is 8.15%. Alternatively, you can analyze Mexican companies in U.S. dollars and use the U.S. treasury bond rate as your riskfree rate or in real terms and do all analysis without an inflation component.,Measurement of the risk premium,The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate. As a general proposition, this premium should be greater than zero increase with the risk aversion of the investors in that market increase with the riskiness of the “average” risk investment,What is your risk premium?,Assume that stocks are the only risky assets and that you are offered two investment options: a riskless investment (say a Government Security), on which you can make 5% a mutual fund of all stocks, on which the returns are uncertain How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund? Less than 5% Between 5 - 7% Between 7 - 9% Between 9 - 11% Between 11- 13% More than 13% Check your premium against the survey premium on my web site.,Risk Aversion and Risk Premiums,If this were the entire market, the risk premium would be a weighted average of the risk premiums demanded by each and every investor. The weights will be determined by the magnitude of wealth that each inves