Private Equity investors often require internal rates of return of more that 25% on the investments...

Private Equity investors often require internal rates of return of more that 25% on the investments they make. 1.How are these required rates of return justified? 2.Explain how the practice of demanding a high risk premium is inconsistent with using expected cash flow forecasts that include a realistic view of the possible downside of the investment to value a business.

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Ans 1)

Rate of return of 25% is considered extremely optimistic and these are only be demanded when there is a higher risk associated with the overall market and there will always be a higher risk free rate than the market premium would also be higher and if it is a higher beta, then such higher expected return is acceptable.

Ans 2)

Practice of demanding a high risk premium is inconsistent with using expected cash flow forecast because there would always be a irregular cash flows to the overall business and the demand of risk premium is only justified when there would be a very high risk free rate and there would be element in the business that it will go insolvent or there is junk rated business so risk premium should always be expected in a certain range which is justified,and it should not be expected a very high rate because those higher rate of return can not be fulfilled by the market always, because there are always downside which are related to the companies as business is not hedged with systematic risk.

ekkarill92 answered 1 year ago

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