Hi guys,

I have a question regarding expected returns on stocks. Expected returns on stocks are calculated using the CAPM model. In the DCF model to value a stock cash flows to equity holders are discounted by this cost of equity (via the wacc). If you calculate the enterprise value using a dcf model, subtract the debt and add the firm's cash you get the equity value of the firm. My question: the cash of the firm is not yet invested and could not earn the expected/ required return. However, the expected return of the stock is for the whole equity value. So, does the firm's cash lower the expected return or is there an assumption that the cash the firm holds, gets reinvested?

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The present value of cash is the current cash value, while the current price of a stock reflects the present value of the future stock price. You are reflecting the present value of the future stock price based on the cost of equity, and then adding the present value of the cash (or net debt) to get the total present value. Since the cash is not invested, and therefore there is no gain from the outflow of cash (like an LBO with a negative cash flow for investment), it is not actually reflected in the NPV of the operations.

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Thanks for the answer, but I still don't quite get it. E.g. you calculate using dcf an enterprise value of 100 with 40 debt and 15 cash. Equity value = 75. The expected return of a stock is equal to the required return of the stock (= cost of equity). So, if the expected return for example is 5%, this is over 75 dollar right? So, there is also an expected return for the cash holdings of the firm?

Or am I overthinking this? DCF is just for valuing a company and should not be compared to asset pricing (expected returns).

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