Corporate Finance, 5th Edition
by Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann Le Fur, Antonio Salvi
Chapter 19 The 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.
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.
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, ...