Reading: Introduction

The preceding modules Time Value of Money and NPV Rule have introduced the basic logic of valuation and financial decision making: It's all about cash flows and discount rates. Put differently:

• We want to know the cash flows that we can expect to earn when we own a financial asset.
• Based on the timing and the riskiness of these cash flows, we want to know the appropriate discount rate, i.e., the rate of return we could earn elsewhere at the same risk. 
• When we capitalize the asset's future cash flows with the appropriate discount rate, we obtain the estimated market value of the asset in question.

The following figure summarizes this basic logic of valuation:

The aforementioned modules discuss in great details the concept of discounting and valuation. In particular, the module NPV Rule shows how to value investment projects with a given set of expected cash flows and a given cost of capital.

In reality, of course, cash flows and discount rates are typically not served to the financial analyst on a silver platter. Quite to the contrary, estimating cash flows and discount rates is one of the major tasks of these analysts. In what follows, we therefore take a closer look at these fundmental elements of financial management.

This module starts with a discussion of the "discount rate." Our understanding so far is that this discount rate captures the rate of return an investor could earn on an alternative asset with identical risk. In this module, we want to learn how to measure the risk of a given project or firm and how to derive the cost of capital based on that measure of risk.

As before, we will use different terms for the same thing. We will speak of the cost of capital, discount rate, risk-adjusted discount rate, required rate of return, and expected rate of return. We will use these terms interchangeably.