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Simultaneous determination of market value and risk premium in the valuation of firms

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  • Stefan Lutz

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Abstract

Valuing a firm using the discounted cash flow method (DCF) requires the joint determination of the market value of its equity (MVE) together with the equity risk premium (ERP) the firm should earn, since the latter is part of the discount rate used in the calculation of the MVE. This paper presents a theoretical derivation of how MVE and ERP can be calculated simultaneously under fairly general conditions. Besides firm data on free cash flow to equity the only external data needed are the risk-free rate of interest and a parameter indicating the required market risk premium per return volatility.

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Bibliographic Info

Paper provided by ICER - International Centre for Economic Research in its series ICER Working Papers with number 15-2011.

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Length: 15 pages
Date of creation: Oct 2011
Date of revision:
Handle: RePEc:icr:wpicer:15-2011

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Keywords: firm valuation; DCF; CAPM; risk premium; transfer pricing;

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  1. André F. Perold, 2004. "The Capital Asset Pricing Model," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 3-24, Summer.
  2. Stefan Lutz & Daniel Kleinfeldt, 2010. "Risk as determinant of income and crossborder pricing of multinational enterprises," The School of Economics Discussion Paper Series 1018, Economics, The University of Manchester.
  3. Fama, Eugene F., 1977. "Risk-adjusted discount rates and capital budgeting under uncertainty," Journal of Financial Economics, Elsevier, vol. 5(1), pages 3-24, August.
  4. R. Cesari, 2003. "Option Pricing and Asset Valuation," Working Papers 467, Dipartimento Scienze Economiche, Universita' di Bologna.
  5. Stefan Lutz, 2012. "Risk premia in multi-national enterprises," ICER Working Papers 08-2012, ICER - International Centre for Economic Research.
  6. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
  7. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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