Globalizing the Cost of Capital and Capital Budgeting at Aes
1. On one half a page review what does our traditional finance framework and the CAPM model, for example, have to say about risk? What is it? How is it approached?
The traditional finance framework uses discounted expected future cash flow to determine the NPV of the project. The amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. People are rational and adverse to risk and need incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principle and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. Virtually all investors would buy the government bond the first is less risky while paying the same interest rate as the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays otherwise no investor is likely to buy that bond. If the firm offering to pay an interest rate more than than 5%, it gives investors an incentive to buy a riskier bond.
The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta
The traditional finance framework uses discounted expected future cash flow to determine the NPV of the project. The amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. People are rational and adverse to risk and need incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principle and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. Virtually all investors would buy the government bond the first is less risky while paying the same interest rate as the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays otherwise no investor is likely to buy that bond. If the firm offering to pay an interest rate more than than 5%, it gives investors an incentive to buy a riskier bond.
The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta