Discounting rules for risky assets

Abstract

This paper develops a rule for calculating a discount rate to value risky projects. The rule assumes that the asset risk can be measured by a single index (e.g., beta), but makes no other assumptions about specific form of the asset pricing model. The rule works for all equilibrium theories of debt and taxes. The rule works because it treats all projects as combinations of two assets: Treasury bills and the market portfolio. We know how to value each of these assets under any theory of debt and taxes and under any assumption about the slope and intercept of the market line for equity securities. Given the corporate tax rate, the interest rate on Treasury bills, and the expected rate of return on the market, we can calculate the cost of capital for a feasible financing strategy. The firm finances the project with equity and debt in the proportions beta and (1- beta). Value increasing projects could be completely financed using this strategy. The weighted average cost of financing this project provides a discount rate that values the project correctly.