Lecture 14 Adjust cash flows or discounts

Question 1

There are two ways to arrive at the same valuation for a set of risky cash flows:

Answer 1

One is to adjust the cash flows for risk. This can be done by recognizing that cash flows will be lower in bad times, than in normal times, and applying probabilities to the outcomes to get (lower) expected values for the cash flows.

The other way is to adjust the discount rate for risk. In other words, leave the cash flows at the values you would expect in normal times, then discount them at a higher rate — one that reflects the greater degree of risk.

Question 2

Theoretical and practical guidance for how to adjust cash flows?

Answer 2

Financial theory tells us to adjust the cash flows for those material risks to the individual firm that can be estimated with some confidence, for example the probability of an adverse regulatory decision, but to incorporate country risk (which is systemic risk) into the discount rate.

If the firm-specific risks to the cash flows can be diversified away, all of the adjustment for risk should be to the discount rate and reflect systematic risk only.

— The decision may hinge on how diversified the investors or the firm’s operations are across countries.

A Monte Carlo simulation — or even a simple “what if” exercise — may help in assessing the sensitivity of the valuation to different ways of incorporating judgments and estimates about risk.