How to Discount Cashflows with Time-Varying Expected Returns
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
University of California, San Diego (UCSD) - Rady School of Management
Journal of Finance, Vol. 59, No. 6, pp. 2745-2783
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.
Keywords: present value, term structure of discount rates, time-varying beta, time-varying risk premium, capital budgeting
JEL Classification: E43, G12Accepted Paper Series
Date posted: April 4, 2005
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