The Term Structure of Discount Rates

Abstract

M.J. Brennan is the Irwin and Goldyne Hearsh Professor of Banking and Finance, University of California, Los Angeles, and Professor of Finance, London Business School. In this paper, I argue that the use of asset-pricing models to infer discount rates for capital budgeting is fraught with difficulties that are rarely addressed. In the case of the CAPM, two problems of major importance are the choice of risk-free rate and of market-risk premium. Choice of the former is not easy for projects that extend beyond a single period. I argue that the use of long-run historical-average excess returns to estimate the market-risk premium is likely to be misleading, not least because the market-risk premium has been found to vary over time in predictable ways. A model is constructed and estimated which allows the analyst to estimate a discount rate that is appropriate for the maturity of a given cash flow and which takes into account current conditions in the capital markets as represented by the level of shortand long-term interest rates and the dividend yield on the market portfolio which affect the market-risk premium.