Risk and Return

FCFt = NOPAT (CAPEXt DEPRt) (NWCt NWCt-1)

E(FCF1)
NPV = E(FCF0) + (1+E(r))1 etc

E(r) = Risk-adjusted opportunity cost of capital

The discount rate or opportunity cost of capital is the expected return E(r) that capital providers could
have earned if they invested in financial security with similar (same) risk as the real asset under
consideration.

Example: opportunity cost of capital for a one-month risk-free project is the rate of a one month
Treasury zero-coupon bond.

What is similar risk?

Assumptions of what investors prefer:

Risk
All else equal, investors prefer high expected returns.
60%

40% All else equal, investors prefer less risk (risk-averse).

20% 0 risk and 10% discount rate = risk free rate

0%
0 0.2 0.4 0.6 0.8

Risk

Discount rate:

Discount = current risk-free rate + estimated asset-specific risk premium

E(r)= rf + rp

Risk free rate can be obtained by using module 2 method.

Rpremium is from portfolio standard deviation and assets contribution to portfolio risks.

Realized return = after vs. Expected returns = before

Pt+1 + Div1 Pt
Rt+1 =
Pt

E(Pt+1) + E(Div1) Pt
E(Rt+1) = Pt

Historical Mean or Average

1
E(r) = =1

Expected return of two risky assets

E(rportfolio) = xE(rj) + (1-x) E(rj)

X represents the fraction of investment in that a particular asset in the portfolio.

What is the expected annualized return of a portfolio that has $100,000 worth of AT&T stock and
$300,000 in Amazon stock?