Private Equity investors often
Private Equity investors often require internal rates of returnof more that 25% on the investments they make. 1.How are theserequired rates of return justified? 2.Explain how the practice ofdemanding a high risk premium is inconsistent with using expectedcash flow forecasts that include a realistic view of the possibledownside of the investment to value a business.
Answer:
Answers
Ans 1)
Rate of return of 25% is considered extremely optimistic andthese are only be demanded when there is a higher risk associatedwith the overall market and there will always be a higher risk freerate than the market premium would also be higher and if it is ahigher beta, then such higher expected return is acceptable.
Ans 2)
Practice of demanding a high risk premium is inconsistent withusing expected cash flow forecast because there would always be airregular cash flows to the overall business and the demand of riskpremium is only justified when there would be a very high risk freerate and there would be element in the business that it will goinsolvent or there is junk rated business so risk premium shouldalways be expected in a certain range which is justified,and itshould not be expected a very high rate because those higher rateof return can not be fulfilled by the market always, because thereare always downside which are related to the companies as businessis not hedged with systematic risk.
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