Such a dependence is characteristic for a risk-adjusted discount rate
(it connects money value change over time with risk represented by a premium for risk).
When it comes to the infrastructure projects, since some risk premiums coming from the uncertainties involved in the projects such as country or sector risk should be added to the cost of equity, actual risk-adjusted discount rate
used in investment analysis can be greater than [R.sub.e].
For this reason, we will use un-leveraged beta to estimate the risk-adjusted discount rate
. To employ the Hamada equation, we used 62 percent debt-to-equity ratio that the firms in this industry have on average.
While the appraiser could adjust the analysis by increasing the discount rate by some amount (a risk-adjusted discount rate
), alternatively the appraiser could calculate loss estimates using high, low, and most-likely dues appreciation rates to account for future cash flow variability.
Assume, for instance, that Google has a risk-adjusted discount rate
of 13.45%, based upon its market risk exposure and current market conditions; the risk-free rate used was 4.25%.
Second, it does not require the estimation of a risk-adjusted discount rate
, since it uses the risk-free rate of interest.
Consider again the initial situation with a 60 percent retention rate for three years but due to an increased level of uncertainty requires a 20 percent versus the initial 15 percent risk-adjusted discount rate
. Required additional cash flows in this case are $68,572, $41,143, and $24,686.
The availability of up-front cash and the resulting risk-adjusted discount rate
establish the cash flow requirement over the horizon in order for the managers to be indifferent.
The fist is discounted cash flow valuation, where the value of a business or asset is determined by its cash flows and can be estimated in one of four ways: (a) expected cash flows can be discounted back at a risk-adjusted discount rate
(b) uncertain cash flows can be converted into certainty equivalents and discounted back at a risk-free rate (c) expected cash flows can be broken down into normal (representing a fair return on capital invested) and excess return cash flows and valued separately and (d) the value of the asset or business is fist estimated on an all-equity funded basis and the effects of debt on value are computed separately.
The problem -- an intractable one -- is in the determination of the risk-adjusted discount rate
for the marginal cash flows.
Otherwise, the DCF model can generate a risk-adjusted discount rate
that contains estimation risk and requires an adjustment such as that outlined in Butler and Schachter (1989).
The project is evaluated as if it were totally equity financed, and each component of the cash flow stream is evaluated at the risk-adjusted discount rate
appropriate for that flow.