Three Discount Methods for Valuing Projects and the Required Return on Equity

Abstract

In this paper we discuss the required return on equity for a simple project with a finite life. To determine a project’s cost of equity, it is quite common to use Modigliani and Miller’s ‘Proposition II’ (1963). However, if the assumptions of MM do not hold, ‘Proposition II’ will lead to wrong required returns and project values. This paper gives an example of how the cost of equity should be determined in order to obtain correct valuations. The methods we apply are the 'Adjusted Present Value' method, the 'Cash Flow to Equity' method and the 'WACC' method.

Keywords: Proposition II, net present value, APV, CFE, WACC

JEL Classification: G12, G31, G32, H43