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Elements of Risk: more than just the investment return

Maximizing total returns is the primary driver for decision-making. When someone purchases a technology or company, they buy a stream of future income. The purchase price is, in essence, this future cash flow, discounted at a determined rate. The higher the risk the higher the discount rate and, consequently, the lower the value.

Elements of risk:

  • Business risk…capacity & capability of management & staff
  • Financial risk…return on investment and opportunity cost
  • Marketability risk…customer demand
  • Interest rate risk…compared to yields from non-risk investments
  • Seniority risk…security of the investment

Total risk is a combination of both systematic risk and unsystematic risk:

  • Systematic risk is relates to movements in returns in the investment market in general
  • Unsystematic risk is a function of the individual company, project or product, and the type of investment interest

Adjusting for risk should be applied in the discount rate (but often it is not) – the discount rate reflects the expected risk of obtaining future income (its likelihood or uncertainty). Keycare's approach is to further refine the discount rate into a Risk-Adjusted Discount Rate. The risk-adjusted discount rate consists of two components: a risk-free rate and risk premium rate.

Risk-Adjusted Discount Rate = Risk-free Rate (Rf) + Risk Premium (Rp)

The Risk Premium

The Risk Premium has an important role in determining the cost of equity capital, which is the expected return rate required by an equity investor to be interested in a particular investment at a particular price. To compensate for the additional risk, investors expect an additional rate of return (over and above a risk-free return).

Although the most accepted and common methods of valuation are the Discounted Cash Flow (DCF), Weighted Average Cost of Capital (WACC) and Capital Asset Pricing Model (CAPM), there are inherent flaws with these methods in determining discount rates. Examples of these flaws include:

  • Failure to measure the overall risk of an asset, and by extension, the value of the investment in it
  • Reliability on historical data that may not reflect the future
  • Using single investment terms
  • Inability to address project-specific risk and project-specific returns

Keycare applies a forward-looking approach, rather than using historical data. Keycare's approach is based on:

  • Applying future volatility from options markets
  • Customized term of the investment for growth, adjusted for investment-specific risk
  • Using a market-driven capital pricing model

As current methods do not do well in developing the risk premium for a specific investment or project, Keycare further developed the Risk Premium portion of the discount rate to properly reflect the type & degree of risk. Keycare adapted accepted valuation methods with an additional assigned project or investment-specific risk factor that can provide a workable alternative in developing more appropriate discount rates.

Keycare has adapted the Risk-Adjusted Discount Rate process to overcome this problem, modifying the Risk Premium through the use of a "Project Premium"

For further information on applying, adjusting and calculating Project Premiums, view the Related Documents at the top of this page for Project Premiums, and examples of the Capital Assest Pricing Model and Calculating Project Cost Equity Capitalusing MPV and Project Premiums.

Related Documents

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