Corporate Finance, 4th Edition

Chapter 19The required rate of return

A ship in a harbour is safe but that is not what ships are built for

The previous chapter described the important concepts of risk, return and the market portfolio. It also highlighted the notion of risk premium (i.e. the difference between the risk-free rate and the return on the market portfolio); this chapter continues to explore the risk premium in greater depth.

By seeking systematically to estimate the risk premium, i.e. in a fairly valued market, the question arises: what risk premium must be added to the risk-free rate to determine the required rate of return?

Investors must look at the big picture, first by investing in the market portfolio, then by borrowing or by investing in risk-free instruments commensurate with the level of risk they wish to assume. This approach allows them to assess an investment by merely determining the additional return and risk it adds to the market portfolio.

Investment risk is often broken down into its component parts, not necessarily in economic and financial terms, but rather into the volatility of the security itself and the volatility of the market as a whole.

We now want to know how to get from r (the discounting rate used in calculating company value) to k (the return required by investors on a specific security).

Remember that this approach applies only if the investor owns a perfectly diversified portfolio.

Here is why: the greater the risk assumed by the financial investor, the higher ...