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

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  • Stefan Lutz

    () (Economics Departments, Institutes and Research Centers in the World, University of Manchester, UK)

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.

Suggested Citation

  • Stefan Lutz, 2012. "Simultaneous determination of market value and risk premium in the valuation of firms," Documentos de Trabajo del ICAE 2012-25, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico, revised Oct 2012.
  • Handle: RePEc:ucm:doicae:1225
    Note: The views expressed in this paper are those of the author and do not necessarily reflect those of the institutions he is affiliated with. Any information presented is of a general nature and does not address individual circumstances of any particular person or entity. The author would like to thank Nils Holinski for helpful comments and suggestions as well as Nitish Maini and Keshav Goel for diligent research assistance; the usual disclaimer applies. Financial support by the International Centre for Economic Research (ICER), Torino, Italy, and by the Spanish Ministry of Education and Science (Grant No. ECO2008-06191) is gratefully acknowledged.
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    References listed on IDEAS

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    1. Stefan Lutz & Daniel Kleinfeldt, 2013. "Risk as Determinant of Income and Cross-border Pricing of Multinational Enterprises," Studies in Microeconomics, , vol. 1(2), pages 185-212, December.
    2. 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.
    3. 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, September.
    4. Lutz, Stefan, 2013. "Risk premia in multi-national enterprises," The North American Journal of Economics and Finance, Elsevier, vol. 25(C), pages 293-305.
    5. André F. Perold, 2004. "The Capital Asset Pricing Model," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 3-24, Summer.
    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. R. Cesari, 2003. "Option Pricing and Asset Valuation," Working Papers 467, Dipartimento Scienze Economiche, Universita' di Bologna.
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    Cited by:

    1. Chia-Lin Chang & Allen, David & McAleer, Michael, 2013. "Recent developments in financial economics and econometrics: An overview," The North American Journal of Economics and Finance, Elsevier, pages 217-226.
    2. Stefan Lutz, 2012. "Effects of taxation on European multi-nationals’ financing and profits," The School of Economics Discussion Paper Series 1214, Economics, The University of Manchester.

    More about this item

    Keywords

    firm valuation; DCF; CAPM; risk premium; transfer pricing.;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M4 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting

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