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Understanding the Relationship Between Discount Rate and Risks

The discount rate for the following equities

A risk-free equity for the US Treasury Note

The definition of the risk-free equity suggests an extreme scenario. The reason why the US Treasury Note is risk free is because it is expected to be free of default risks. In other words, it is not always possible that the US Treasury Note would be defaulted hence, considered risk free of any default. Therefore, it is deemed to be the safest type of equity since it is backed by the US treasury. For such less risky investment, one would need a return of not more than 10%.

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A CD at a South American bank paying in their local currency

There is a greater risk of inflation as a result of currency risk relating to the instabilities which accrue due to political and economic situations within the South American countries. The consequence of inflation is that the currency would lose its value. To compensate for the risk, a greater rate of return would be required probably between 15% and 20%. Hence, this type of investment would attract a discount rate of between 15 and 20%.

Stocks in a company that has secure returns from long-term contracts

If one expects steady long-term returns to the firm, he would also expect investments for the company stock that would be safer. Further, the investor would expect steady returns on dividends from the company. In such a situation, the investor would chose a low discount rate of not more than 10% since the prices of stocks are not due to reduce within a short period.

Stocks of a company having interesting business plan

Approaches to discount rates including the Constant Growth Model apply the future expectations in calculating the performance of the company stocks. The future expectations are based on the actual growth rate and dividend payment from the company. In situations where solid and real basis upon which one can base his investment decision is lacking, then it would be advisable that one should not undertake such kind of investment. However, one would decide to take risk and invest on such stocks but with a greater return of more than 25% in order to recompense for the high risks involved.

Discussions

Discount rates can be described as the proportion in which the discounted cash flows are reduced each time in the future (Bailey & Michael, 1972). One of the difficulties investors face is determining the discount rate is that it involves uncertainties in the discounted cash flow (DCF). Further, a small change in the interest rate may result in a huge change in the final future value. Normally, the discount rates that analysts use in their calculations and the cost of capital are taken to be equal (Bailey & Michael, 1972). Therefore, some adjustments must be made to take into consideration the uncertainty risks related to the cash flow.

Models such as capital asset pricing takes into consideration the risk related variables while determining the discount rate. These include the risk-free rate which is the percentage returns from risk-free investments such as the government securities. The other variable is beta which is the response of the stocks to the market risks. Also is the stock market risk premium which is the return on investment greater than the required risk-free rate. Considering all these variables, the discount rate would be risk-free rate plus beta multiplied by the stock market risk premium (Pannell & Steven, 2006).

The relationship between risks and discount rates should be taken into consideration during the DCF analysis since all the discount rate adjustments has to take into account the future cash flow risks (Pannell & Steven, 2006). The investors are expected to have knowledge of the correlation that exists between future returns and the quantity of risks involved. Investors who are risk-averse would tend to hold risk-free assets with expected low returns. As a result, to attract such kind of investors, discount rate of the company must be increased.

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References

Bailey, M. & Michael, J. (1972). Risk and the discount rate for public investment. Studies in the Theory of Capital Markets. New York, NY: Praeger.

Pannell, D. & Steven G. (2006). Economics and the Future: Time and discounting in private and public decision making. Cheltenham, UK: Edward Elgar Publishing.

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