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3 - Portfolio Theory and the Discount Rate

Published online by Cambridge University Press:  09 February 2017

Raghavendra Rau
Raghavendra Rau
Affiliation:
Judge Business School, Cambridge
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Summary

In Chapter 2, we discussed the major inputs into the NPV formula (equation 2.1): The two obvious inputs are the cash flows and the discount rate (the non-obvious input – the capital structure of the firm – will be discussed in Chapter 4, on capital structure).

The cash flows are given by the characteristics of the asset. Suppose our investor, Galadriel (from Chapter 2, now rescued from the island) expects a cash flow of $100 as a dividend from a popular ring and assorted jewelry firm, Sauron Inc., two years from now. Unfortunately, it is not a certain $100 – there is a 50% probability that the firm will actually pay $200 and a 50% probability that the firm will pay nothing.

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Short Introduction to Corporate Finance , pp. 42 - 69
Publisher: Cambridge University Press
Print publication year: 2016

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