CAPM Modification for correct risk assessment in discounted cash flow method

Economic & mathematical methods and models

The discounted cash flow method is currently one of the main methods used to evaluate both financial (stocks, bonds, etc.) and real assets (investment projects, business, etc.). Correct implementation of this method is extremely important for making reasonable and objective management decisions. An important role in the existing practice of the method’s application is played by the discount rate, including, according to tradition, not only the time value of money but also the risks associated with the asset. However, the generally accepted approach to discounting, which assumes using a single rate (whose role is played by the required yield estimated by one of many existing methods), can adequately estimate risks only for assets that generate only one type of cash flow (financial assets). The fact is that all risks for assets generating both inflows and outflows (real assets) can be divided into two categories: the risk that the actual inflows will be less than the expected inflows (risk of the first kind) and the risk that the actual outflows will be more than the expected outflows (risk of the second kind). Discounting of net cash flows assumes that the risk premium taken into account in the required return leads to a decrease in the discounted amount of inflows (correct assessment of risks of the first kind) but at the same time reduces the discounted amount of outflows (incorrect assessment of risks of the second kind). To address this shortcoming, the present paper proposes a methodology for separate assessment of risks of the first and second kind, based on the widespread capital assets pricing model (CAPM) and assuming that betas and discount rates are calculated separately for inflows and outflows. As shown in the paper using the example of investment project evaluation, this approach allows obtaining results that differ significantly from the results of the assessment based on the generally accepted approach. Differences arise due to correct assessment of risks of the second kind in the proposed methodology, which allows to recommend it for use in the discounted cash flow method when assessing real assets. It seems that this will make it possible to achieve maximum validity and objectivity for valuation of assets of this type and will improve the quality of management decisions made on the basis of the discounted cash flow method.