Question

How do we reflect risk in DCF modeling? What factors can be adjusted in the model inputs to represent a higher risk versus lower risk project?

Answer 1

In DCF modelling risk is measured as cost of equity or the required return paid to the investors for investing.

The cost of equity is the denominator by which Dividend and terminal values are divided.

The most frequent way to calculate risk is the CAPM model, which takes into account following equation

Cost of equity = risk free rate + beta ( market risk premium)

Risk free rate is the return on the government securities

Beta measures the systematic risk components and is the degree of elasticity to which the stock's return will change wrt to market

Market risk premium is the average return of market

For higher risk projects, we can increase the value of beta in the equation and vice versa as an accountability factor for systematic risk.

Also for more risky projects in order to account risk, we can include multiple risk factors like company size risk, market capitalisation risk etc, each of the factors will need to be multiplied by thier coefficients

I hope this helps

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