I have received many helpful comments from John Clapp, Erasmo Giambona, Joe Golec, John Harding, Shantaram Hegde, Hossein Kazemi, Tom O'Brien, Rex Santerre, Jimmy Sfiridis, You Taewoo, John Vernon, and seminar participants at the University of Connecticut, the University of Massachusetts, and the 2006 Eastern Finance Association in Philadelphia. I thank also an anonymous referee and Arnie Cowan (the editor) for their valuable comments. All remaining errors are the sole responsibility of the author.
Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model
Article first published online: 5 JUN 2007
Volume 42, Issue 2, pages 247–265, May 2007
How to Cite
Giaccotto, C. (2007), Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model. Financial Review, 42: 247–265. doi: 10.1111/j.1540-6288.2007.00170.x
- Issue published online: 5 JUN 2007
- Article first published online: 5 JUN 2007
- equilibrium cost of capital;
- capital budgeting;
- Gibbs sampling;
- Monte Carlo Markov Chain
Discounting cash flows requires an equilibrium model to determine the cost of capital. The CAPM of Sharpe 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.