Chapter 6: Relationship between Risk

and the Cost of Capital

 Introduction
 Defining Risk
 How Risk Affects the Cost of Capital
Valuation of Risky Net Cash Flows
Risk Aversion versus Risk Neutrality
Market Returns Increase as Risk Increases by Asset Class
 Types of Risk
Maturity Risk
Market Risk
Company-specific Risk
Liquidity and Marketability Risk
Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 1
 Chapter 6: Relationship between Risk
and the Cost of Capital (cont.)
 Measuring Riskiness of Net Cash Flows
 ASC 820 Fair Value Measurement: Cash Flows and Present
Value Discount Rates
 Summary

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 2

 Defining Risk
Probably the most widely accepted definition of risk in the context
of business valuation is the degree of uncertainty (or lack thereof)
of achieving future expectations at the times and in the amounts
expected.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 3

 How Risk Affects the Cost of Capital
The cost of capital for any given investment is a combination of two
basic factors: a risk-free rate, Rf, and a premium for risk, RP.
Risk is a major concern of investors. The risk-free rate compensates
investors for renting out their money (i.e., for delaying consumption
over some future time period and receiving back currency with less
purchasing power in the future).
The risk premium results from the uncertainty of expected returns and
varies widely from one prospective capital investment to another. We
could say that the market abhors uncertainty and consequently
requires a high rate of return to accept uncertainty. Since uncertainty
as to timing and amounts of future net cash flow is greatest for equity
investors, the high risk requires equity as a class of capital to have the
greatest cost of capital.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 4

 Valuation of Risky Net Cash Flows (cont.)

Exhibit 6.1 Valuation of Risky Net Cash Flows with Symmetrical Distributions

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 5

 Valuation of Risky Net Cash Flows (cont.)

Exhibit 6.2 Valuation of Risky Net Cash Flows with Skewed Distributions

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 6

 Valuation of Risky Net Cash Flows (cont.)
Calculating a measure of central tendency (e.g., expected value)
by probability-weighting the expected cash flows does not eliminate
the risk of the distributions.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 7

 Risk Aversion versus Risk Neutrality
 The present value of this series of contingent claims can be depicted in the
following formula:
(Formula 6.2)

 If investors were risk neutral, the appropriate discount rate for estimating the
present value of the expected cash flows would be the risk-free rate.
 But investors are not risk neutral; in the literature, investors are generally
assumed to be risk averse.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 8

 Risk Aversion versus Risk Neutrality (cont.)

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 9

 Risk Aversion versus Risk Neutrality (cont.)

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 10

 Risk Aversion versus Risk Neutrality (cont.)

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 11

 Market Returns Increase as Risk
Increases by Asset Class

Exhibit 6.5 Capital Market Line—Empirical Estimate Based on Realized Returns by Asset Class

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 12

 Types of Risk
Although risk arises from many sources, this chapter addresses risk
in the economic sense, as used in the conventional methods of
estimating cost of capital. In this context, capital market theory
divides risk into four components:
1. Maturity risk
2. Market risk
3. Company-specific risk
4. Liquidity and marketability risk

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 13

 Measuring Riskiness of Net Cash Flows
All businesses are portfolios of operations and assets. The risk of
the expected cash flows can be thought of in terms of the risk of
company operations and assets (business risk) and the risk of how
it’s financed (financial risk).
 Business risk is the risk of the company operations.
 The capital structure of the business adds another layer of risk,
financial risk. Financial risk is the added volatility providers of
equity capital will experience because returns to debt holders and
other preferred investors generally are fixed and are senior to
returns on common equity.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 14

 ASC 820 Fair Value Measurement: Cash
Flows and Present Value Discount Rates
 Accounting Standards Codification (ASC) Topic 820 Fair Value
Measurement addresses issues surrounding the use of cash flow
projections and present value techniques in financial reporting of
fair value measurements.
 Practitioners are required to use the ASC 820 framework
implementing ASC Topic 805 Business Combinations and Topic
350 Intangibles—Goodwill and Other Prior to the Codification,
FASB Statement No. 157, Fair Value Measurements.
 ASC 820 clarifies the guidance provided in Financial Accounting
Standards Board's Concepts Statement No. 7 (Con 7), Using Cash
Flow and Present Value in Accounting Measures; Con 7 now
representsnon-authoritative guidance. See ASC 820-10-55-4.

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 15

ASC 820 Fair Value Measurement: Cash Flows
and Present Value Discount Rates (cont.)
The present value techniques guidance was clarified in ASC 820,
specifically at ASC 820-10-55-9, by identifying three present value
techniques:
Discount rate adjustment technique (the “bond trader” approach)
uses a risk-adjusted discount rate and contractual, promised, or
most likely cash flows.
Method 1 of the expected present value technique uses a risk-free
rate and risk-adjusted expected cash flows (termed the traditional
method in Con 7.
Method 2 of the expected present value technique uses a risk-
adjusted discount rate (which is different from the rate used in the
discount rate adjustment technique) and expected cash flows
(termed the expected value method in Con 7).

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 16

ASC 820 Fair Value Measurement: Cash Flows
and Present Value Discount Rates (cont.)
The terminology can cause confusion and we will relate the ASC
terminology to the terminology found in a standard finance textbook.
In ASC 820, the FASB expanded the guidance on Con 7 to clarify
that when using an expected present value technique, the
adjustment for risk may be reflected either in the expected cash flows
(the numerator) or in the discount rate (a risk-adjusted discount rate).
“Risk is an essential element in any present value technique.
Therefore, a fair value measurement, using present value, should
include an adjustment for risk if market participants would include
one in pricing the related asset or liability.”

Cost of Capital: Applications and Examples 5 th ed. Chapter 6 - 17