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)