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MARKET RISK ADJUSTMENT IN PROJECT VALUATION

MARKET RISK ADJUSTMENT IN PROJECT VALUATION INTRODUCTION THIS PAPER DEVELOPS A RULE which reduces the problem of valuation in the presence of market risk to the problem of valuation in a world where the market price of risk is zero. Given a valuation problem in an intertemporal, continuous time framework, the rule is applied in two steps as follows: We first replace one or more of the model parameters by their "effective values" in a specified way. Then we discount all expected cash flows at the riskless rate of return as if the market price of risk were zero. The broad applicability of the valuation rule is illustrated through the diverse examples of asset valuation, option pricing, determination of the optimal capital structure of a firm, and cash management. We motivate the discussion of this paper by briefly examining a forerunner to our valuation rule, the certainty equivalence approach to evaluating a stream of cash flows. In a single period model, the risk-adjusted net present value RANPV(X) of the cash flow X, realized at the end of the period, is given by the single period Sharpe-Lintner capital asset pricing model (CAPM) as Essentially this formula states that the expected cash flow X is adjusted http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

MARKET RISK ADJUSTMENT IN PROJECT VALUATION

The Journal of Finance , Volume 33 (2) – May 1, 1978

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References (15)

Publisher
Wiley
Copyright
1978 The American Finance Association
ISSN
0022-1082
eISSN
1540-6261
DOI
10.1111/j.1540-6261.1978.tb04870.x
Publisher site
See Article on Publisher Site

Abstract

INTRODUCTION THIS PAPER DEVELOPS A RULE which reduces the problem of valuation in the presence of market risk to the problem of valuation in a world where the market price of risk is zero. Given a valuation problem in an intertemporal, continuous time framework, the rule is applied in two steps as follows: We first replace one or more of the model parameters by their "effective values" in a specified way. Then we discount all expected cash flows at the riskless rate of return as if the market price of risk were zero. The broad applicability of the valuation rule is illustrated through the diverse examples of asset valuation, option pricing, determination of the optimal capital structure of a firm, and cash management. We motivate the discussion of this paper by briefly examining a forerunner to our valuation rule, the certainty equivalence approach to evaluating a stream of cash flows. In a single period model, the risk-adjusted net present value RANPV(X) of the cash flow X, realized at the end of the period, is given by the single period Sharpe-Lintner capital asset pricing model (CAPM) as Essentially this formula states that the expected cash flow X is adjusted

Journal

The Journal of FinanceWiley

Published: May 1, 1978

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