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How to Discount Cashflows with Time-Varying Expected Returns

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  • Andrew Ang
  • Jun Liu

Abstract

While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time-varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk-free rates, predictable risk premiums and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large mis-valuations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time-variation in risk-free rates and factor loadings.

Suggested Citation

  • Andrew Ang & Jun Liu, 2003. "How to Discount Cashflows with Time-Varying Expected Returns," NBER Working Papers 10042, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10042
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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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