WFU Law School
Law & Valuation
4.1.1 Cash Flow (Returns)

4.1.2 Required Return (Discount Rate)

An investment's riskiness affects its value. The greater the uncertainty of cash flows, the lower their value. Risk can be factored into the valuation process by either increasing the discount rate or formalizing it in a model (such as the Capital Asset Pricing Model) that relates risk (ß) and returns.

For example, suppose you own a beach condo that you expect to sell in three years for $120,000. Its value today depends a lot on how much you can count on this price:

Certainty
Risk
If a reliable, well-established real estate dealer has offered to buy the condo for $120,000 in 3 years, you could be pretty sure of the sale. You might consider the condo investment to have the attributes of a 3-year T-bill -- for which there is virtually no risk of less-than-full payment. If the prevailing risk-free rate is 5.2% (the current time value of money), you can determine the present value of the condo. If you are not sure what price you'll get in 3 years, your estimate of $120,000 assumes a good deal of risk. If you the future price could fluctuate between $80,000 and $200,000 depending on market conditions, the condo investment has the attributes of high-risk common stock. If the prevailing expected return for high-risk common stock is 18% (required return), you can determine the condo's value.

Often the appropriate discount rate will be the most significant contention in a valuation. As the discount rate rises, the expected value falls. For example, an 8% discount rate results in a valuation that is twice as large as a 16% discount rate.

Example

Return to Estate of William J. Desmond, v. Commissioner of Internal Revenue In its valuation of Deft Inc., the Tax Court accepted the taxpayer's discount rates.

Year
Discount rate
1992
19%
1993
19%
1994
19%
1995
19%
1996
19%
1997 and thereafter
19%

The Desmond court's use of a single discount rate is a common method in valuation. Generally, valuators will choose a single discount rate for a particular investment--taking into account both risk-free time value of money and the particular risk of the investment. But this does not have to be the case. In fact, the recent Concept Release by FASB suggests that valuators should consider using different discount rates to reflect changes in risk of cash flows, even when all cash flows are generated from the same investment.

4.1.1 Cash Flow (Returns)

©2003 Professor Alan R. Palmiter

This page was last updated on: March 30, 2004