Question

Question: What does he mean by adjusting the cash flows for risk (rather than the discount rate itself)

Before answering these questions please watch the 3 Damodaran Videos and answer the following question. Intrinsic Valuation

Answer 1

Let me explain the 3 damodaran's Video:

There are 3 basic principles which driving business :

1) Investment decision :Investment decison is nothing but take a good project, and the rate should be more than your expected rate of return that is the basic Rule

2)Financing decision : Find the better mix of debt and Equity, which gives more cash to the business

3) Dividend Decison : Dividend decision is nothing but giving back share holders money if business not find better way to invest.

To illustrate adjusting the cash flows for risk , let me provide a simple example. Assume that you have an investment, where there are two scenarios: a good scenario, where you make $ 100 instantly and a bad one, where you lose $ 30 instantly. Assume also that the likelihood of each scenario occurring is 50%. The expected cash flow on this investment is $35 (0.50*$100 + 0.50*- $30). A risk neutral investor would be willing to pay $ 35 for this investment but a risk averse investor would not. He would pay less than $ 35, with how much less depending upon how risk averse he was. The amount he would be willing to pay would be the certainty equivalent cash flow.

Risk-averse investors will assign lower values to assets that have more risk associated with them than to otherwise similar assets that are less risky. The most common way of adjusting for risk to compute a value that is risk adjusted