Question

What is the role of the required return on equity investments in stock valuation models?

Why would a crisis in the subprime mortgage market lead to declining prices in the U.S. equity markets?

Answer 1

Discounted cash flow method use the present value of cash flows discounted at required rate of return.
It takes into consideration the expected free cash flows over the life of the project. These free cash flows are forecasted based on assumptions. The WACC is calculated by the average weighted cost of debt, equity and preferred stock. This method is used to value bonds, firms, projects etc.

Discounted Cash flow = FCF in year 1/(1+r) +FCF in year 2/(1+r ^2+FCF in year 3/(1+r)^3 +.FCF in year n/(1+r)^n

It also used in dividend discount model which is given by following formula
Price of stock =Dividend*(1+growth)/(Required rate-Growth)
This method is useful in dividend paying stock with constant growth.


Loans were provided to subprime borrowers for housing loan. Subprime borrowers are not credit worthy borrowers who are loaned without any security .This created a housing bubble as housing loans increased. Moreover down payment were required for loans . These further increased the risk . .Hence the risk of default had increased. Moreover they were provided with loans without any security which further increased the risk of default. During the housing bubble the prices of housing decreased due to increased supply of houses. Hence in the case any borrower defaulted the recovery could not be complete. Since this was done by most banks it created a full blown crisis when many borrowers defaulted and the US economy went into a recession. Liquidity in the economy decreased and interest rates went up . This impacted the companies in a negative way as interest payments increased, lower demand decreases revenue and profits. This impacted the equity market. Moreover money invested moved to debt ore treasury securities which were more secure than equity markets.These all contributed to decline in price if US equity market.