Question

How does change in risk impacts return and firm's value.

Answer 1

Value of firm is the present value of its future cash flows

The firm's future cash flows are its operating cash flows from operating the business.

The present value of future cash flows is calculated using the present value concept and time value of money. As per these concepts, the discount rate used to calculate the present value inversely impacts the present value. Higher the discount rate, lower the present value and lower the discount rate, higher the present value

The discount rate to use in discounting a firm's future cash flows is the required return of investors. The required return of investors is the minimum return required by the suppliers of capital (equity, debt, and preferred stock) to compensate them for the risk of investing in the project. In other words, it is the required return of the investors.

A business with higher risk will have a higher required return to compensate for the higher risk to investors. A business with lower risk will have a lower required return.

A higher risk results in a higher required return, which decreases the present value of cash flows (the firm value)

A lower risk results in a lower required return, which increases the present value of cash flows (the firm value)