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Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model

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  • Carmelo Giaccotto

Abstract

Discounting cash flows requires an equilibrium model to determine the cost of capital. The CAPM of Sharpe and the intertemporal asset pricing model of Merton (1973) offer a theoretical justification for discounting at a constant risk adjusted rate. Two problems arise with this application. First, for mean reverting cash flows the risk adjustment is unknown, and second, if the present value is compounded forward then the distribution of future wealth is likely right skewed. I develop equilibrium discount rates for cash flows whose level or growth rate is mean reverting. Serial correlation also largely eliminates the skewness problem.

Suggested Citation

  • Carmelo Giaccotto, 2007. "Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model," The Financial Review, Eastern Finance Association, vol. 42(2), pages 247-265, May.
    • Handle: RePEc:bla:finrev:v:42:y:2007:i:2:p:247-265
    DOI: 10.1111/j.1540-6288.2007.00170.x
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