Discounting Mean Reverting Cash Flows With the Capital Asset Pricing Model

Posted: 26 Apr 2007

See all articles by Carmelo Giaccotto

Carmelo Giaccotto

University of Connecticut - Department of Finance

Abstract

Discounting cash flows requires an equilibrium model to determine the cost of capital. The CAPM of Sharpe (1964) and the intertemporal asset pricing model of Merton (1973) offer a theoretical justification for discounting at a constant risk adjusted rate. Two problems arise with this application. First, for mean reverting cash-flows the risk adjustment is unknown, and second, if the present value is compounded forward then the distribution of future wealth is likely right skewed. I develop equilibrium discount rates for cash flows whose level or growth rate is mean reverting. Serial correlation also largely eliminates the skewness problem.

Keywords: CAPM, Equilibrium Cost of Capital, Capital Budgeting, Gibbs Sampling, Monte Carlo Markov Chain

JEL Classification: G11, G12, G31

Suggested Citation

Giaccotto, Carmelo, Discounting Mean Reverting Cash Flows With the Capital Asset Pricing Model. Financial Review, Vol. 42, No. 2, May 2007, Available at SSRN: https://ssrn.com/abstract=982251

Carmelo Giaccotto (Contact Author)

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States
202-486-4360 (Phone)
202-486-0349 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
679
PlumX Metrics