This is the second basic principle of finance. Future cash flows are not certain. However, some are more certain than others. You can be more certain of future values of government securities, for example, than of the future values of the stock market.
Different investments have also different levels of uncertainty or risk. The concept of present value as defined in the previous post can help with risky investments as well. In the present value calculation the future cash flows are discounted by the rate of return offered by comparable investments. The choice of these comparable investments will depend on how risky the investment project is.
Let’s come back to the example from the previous post. Suppose that in the calculation there the investment was comparable with investments in government securities. And suppose we expected government securities to provide a 6 percent rate of return, which led to the choice of this rate in our calculation. The $100 investment today with the $120 payoff a year from now led then to an NPV of $13.
Let’s use now a second example of similar $100 investment and $120 payoff a year from now. But this time let’s assume that the project is as risky as investments in the stock market. And suppose that we forecast a 12 percent rate of return for the stock market.
For this more risky investment the NPV would be $7 as calculated below. This new NPV is $6 lower than calculated previously since the investment project is now riskier than the previous one. The previous safer investment was worth more than the new riskier investment.
Unfortunately, finding the correct rate of return through comparable investment alternatives is more complicated than our two examples suggest. One proven approach is the use of a risk matrix. The risk matrix helps to weigh several risk factors that drive the risk of an investment. Such a risk matrix provides also a consistent approach to determine the rate of return for every investment project throughout the company. Whatever approach you choose, it’s crucial to use the same approach consistently to make apples-to-apples comparisons between safe and risky investments.