The adjustments that we have suggested for country risk so far in this paper have all been directed at the discount rates – costs of equity and capital. Can we adjust cashflows for risk? Absolutely, but before we look at how, we should dispense with some widely held misconceptions about cashflow adjustment:
• Adjusting the cashflows to reflect expectations about dire scenarios arising from political or economic turmoil is not risk adjustment. For instance, assume that you are a company investing in a large telecommunications project in China and that you expect to generate $ 1 billion in cashflows each year if the economy remains vibrant. However, your risk assessment experts tell you that there is a 10% chance of political and economic turmoil, in which case you expect to lose $ 500 million a year. You could compute an expected cashflow from these inputs: Expected Cashflow = 1000 (.90) – 500 (.10) = $ 850 million If you use this expected cashflow in your analysis, you have not adjusted for risk yet. All you have done is compute expected cashflows correctly.
• Doing Monte Carlo simulations on the cashflows or returns on an investment may give you a better sense of the risk in an investment, but they do not represent risk adjustments. The expected value across your simulations should converge on the expected value that you would have obtained with a single, base case analysis, assuming your estimates in the analysis are done correctly.
• Arbitrary reductions in the cashflows – hair cuts of 10% or 20% to the expected cashflows to reflect the fact that they are risky – may yield conservative estimates of value but do not represent real risk adjustment.
So, how can we adjust cashflows for risk? Instead of adding the risk premium to the riskfree rate, as we did in the earlier sections, we could adjust the expected cashflows for the risk. As an example, consider the cost of equity that we estimated for Embraer of 10.67% in the last section, which represents a risk premium of 6.62% over the riskfree rate. Assume that you have projected expected cashflows of $ 200 million for next year and $ 250 million for the year after for Embraer. The risk adjusted cashflows for these two years would be:
Risk adjusted cashflow for year 1 = $ 200/ 1.0662 = $187.58 million
Risk adjusted cashflow for year 2 = $ 250/1.06622 = $219.92 million
These cashflows would then be discounted at the riskless rate to yield almost the same value as you would have obtained with the risk adjusted discount rate approach14.
14 If you want the same value, the risk premium you use will be slightly different and computed thus:
Prof. Aswath Damodaran
Next: Conclusion
Summary: Index