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FINANCIAL ECONOMICS CLEMSON UNIVERSITY COMPUTING THE DISCOUNT RATE The Risk and Cash Flow What we have discovered over that last month and a half is that the stock price of a company is based on the Discounted Cash Flow that the firm is expected to enjoy over the foreseeable future There are two elements of the DCF equation One the cash flows must be forecast Two the appropriate discount rate must be chosen Market participants are constantly working to evaluate the price of each stock to determine whether it correctly reflects its fundamental DCF value P t 0 CashFlowt 1 r t Insiders and information gatherers acquire knowledge about the cash flows that a company can anticipate These people study markets and products managerial decisions and corporate policies From this study they make informed opinions about the future cash flows of a company Uninformed investors are investors with no special knowledge about the future cash flows of a company They know what is publicly available and do not spend resource to discover new information They are risk averse They form portfolios of assets in order to achieve the highest possible utility by trading off return for lower risk Portfolio diversification has the effect of lowering risk holding return constant In the process of choosing among assets to hold in their portfolios uninformed investors minimize variance by holding many many different assets In the limit they hold all assets The amount of each asset that they hold is based on the correlation of the return of that asset to all other assets In choosing among assets investors force the returns of each asset to obey the Capital Asset Pricing Model That is the CAPM identifies the expected return to each asset 1 E ri rf E rm rf This expected return is the rate of return at which the firm s cash flows are discounted We can think of the CAPM market model 2 rit i i rmt it as embodying these two components of the price of a stock The parameters and are the discount rate

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