RISK AND OPPORTUNITY COST OF CAPITAL
Asset Pricing

Asset pricing and valuation in markets can be stated broadly as what a buyer willing to buy, and a seller willing to sell, would agree to be an assets fair value. With income producing assets, however, there have been developed a series of formulas which are universally recognized and applied to such assets as stocks and bonds, real estate, and businesses of every kind.

Each of these diverse valuation formulas have universal components which underlie the value of everything that has income producing potential. The chief component is the cash flows to be received by the investor over a specific time frame, called the "holding period". Since all assets are purchased with after-tax dollars, all cash flows to be evaluated have to be reduced to cash-flows-after-tax., which involves gross cash flow estimations and the development of accounting net profit by subtracting manufacturing, operating and financial expenses, including taxes, and then adding back to the net profit those non cash charges, such as depreciation, to develop the net after tax cash flow.

Once estimated cash flows have been developed, the risk-return percentage for the receipt of those cash flows has to be calculated. In other words, in order to place a value on the receipt of those flows, the buyer need a sense of the percentage of return to which he is entitled to be appropriately compensated for the risk undertaken in purchasing them. This sense of the required rate of return can be most readily determined in the market, where the buyer of such cash flows can determine what others, who have recently purchased cash flows from similar business, were willing to pay for those cash flows. In other words, the sense of this percentage is cash flows/price. For example, if the cash flows were $100,000 per year and the price paid for them was $1,000,000, that means that a recent buyer required a 10% annual return on the investment purchased. If a buyer of cash flows does not have recent market transactions to refer to, then its important to have an analogous product or company to reference.

In the prior example, we assumed that the cash flows of $100,000 would not change. The third element in the valuation of any asset is the projected growth of the cash flows. This idea was captured by a financial thinker named Gordon who devised a formula which recognizes the three elements of asset value: cash flow, risk, and cash flow growth. The Gordon formula, otherwise known as the Constant Growth Dividend Valuation Model, is that the value or price of any asset is:

V = C/(R-G).

In our prior example, if the cash flow was $100,000, the risk was 10% and the growth of those cash flows was assumed to be 5%, then the value of the asset would be:

$100,000/(.10-.05) = $2,000,000.

Or to put it another way, if the buyer paid $2,000,000 for that asset and did realize an annual return of $100,000, growing at 5%, the buyers return would be:

R=C/P +G = $100,000/$2,000,000 + .05= .10


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