Damodaran on Valuation

Chapter 2. Estimating Discount Rates

In discounted cash flow valuations, the discount rates used should reflect the riskiness of the cash flows. In particular, the cost of debt has to incorporate a default premium or spread for the default risk in the debt, and the cost of equity has to include a risk premium for equity risk. But how do we measure default and equity risk, and more importantly, how do we come up with the default and equity risk premiums?

In this chapter, we lay the foundations for analyzing risk in valuation. We present alternative models for measuring risk and converting these risk measures into acceptable hurdle rates. We begin with a discussion of equity risk and examine the distinction between diversifiable and nondiversifiable risk and why only the latter matters to a diversified investor. We also look at how different risk and return models in finance attempt to measure this nondiversifiable risk. In the second part of this chapter, we consider default risk and how it is measured by ratings agencies. In addition, we discuss the determinants of the default spread and why the default spread might change over time. Finally, we will bring the discussion to fruition by combining the cost of equity and the cost of debt to estimate a cost of capital.