(BQ) Part 2 book "Stock valuation - An essential guide to wall street's most popular valuation models" has contents: Capital structure and the cost of capital, forecasting, valuing employee stock options, the discounted cash flow model. | This page intentionally left blank CHAPTER 6 Capital Structure and the Cost of Capital PURPOSE AND SCOPE Perhaps the most difficult concept we must address is the relationship between risk and return. This relationship is critical to company managers because it determines how great a return they must generate in order to satisfy the company’s investors. It is critical to us for the same reason. At the core of stock valuation is the notion that we must calculate the present value of expected cash flows. We therefore have two main tasks: 1) estimate the future cash flows and 2) estimate the appropriate discount rate for use in discounting those cash flows. The appropriate discount rate is simply the lowest return that will satisfy the company’s investors. In other words, it is the return that exactly compensates investors for the risk associated with the investment. Another way to look at the appropriate discount rate is that it is the expected return on alternative investments of equivalent risk. If the investment under consideration has an expected return below the expected return on some other investment with the same risk, we would of course prefer the alternative. It follows that we must understand how to measure risk before we can determine the appropriate discount rate. To understand the relationship between risk and return, we must first note the obvious—higher risk must be associated with higher expected returns. If that were not the case, then rational risk-averse investors would avoid the high-risk investments with low expected returns, 163 Copyright © 2006 by The McGraw-Hill Companies, Inc. Click here for terms of use. 164 Stock Valuation leading to a disequilibrium in the marketplace. For example, startup tech stocks clearly tend to be riskier than well-established conglomerates. Hence, investors would not rationally purchase tech stocks unless they expected to receive a higher return. Our desire (and the purpose of this chapter) is to .
