Specifically, we explore whether adding risk factors to cost of equity models improves their predictive power both for individual firms and firm portfolios. We test this implication by evaluating six commonly used methods for cost of equity estimation, contrasting them with a single factor model. Individual empirical tests conducted on cost of equity estimation methods increasingly have implied that sophisticated models are no more accurate than the simplest approaches. It explores the complications introduced by institutional limits on amounts that either individuals or corporations may borrow at given rates, by rising costs of borrowed funds, and certain other real world complications. The chapter considers a few implications of the results for the normative aspects of the capital budgeting decisions of a company whose stock is traded in the market. It discusses various significant equilibrium properties within the risk asset portfolio. The chapter focuses on the set of risk assets held in risk averters' portfolios.
It presents alternative and more transparent proofs under these more general market conditions for Tobin's important separation theorem that “ … the proportionate composition of the non-cash assets is independent of their aggregate share of the investment balance … and for risk avertere in purely competitive markets when utility functions are quadratic or rates of return are multivariate normal. This chapter discusses the problem of selecting optimal security portfolios by risk-averse investors who have the alternative of investing in risk-free securities with a positive return or borrowing at the same rate of interest and who can sell short if they wish. Hence, if the manager will receive relatively precise pre-decision information, then it is optimal to charge him more than the riskless return to reduce the variability of his investment decisions. On the other hand, the manager will vary his investment decisions with the pre-decision information he receives, which accentuates his compensation risk, and the firm must compensate him for bearing this additional risk. If the manager faces significant firm-specific risk at the time he makes his investment decision, then it is optimal to charge him less than the riskless return so as to partially offset his reluctance to undertake risky investments. Second, while investors can avoid firm-specific risk through diversification, a manager cannot. Charging a market risk premium results in "double" counting because a risk-averse manager will personally consider this risk. First, the capital charge should not be adjusted for market risk. We demonstrate two basic flaws in this recommendation. Textbooks often recommend adjusting the residual income capital charge for market risk, but not for firm-specific risk. We consider a setting in which a firm uses residual income to motivate a manager's investment decision.
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