No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 402 As you may recall, we said that risk could be captured by a probability distribution of possible outcomes, such that the outcome could be predicted (and known , on average). Uncertainty, however, was associated with true ignorance of the future; not only can we not assign a probability to each possible outcome, we don’t necessarily know what each possible outcome is! Nevertheless, in finance, risk is associated with the variability of returns of an asset and is helpful in making comparisons between differing investments. While past returns are not necessarily predictors of future performance, they are often the best an entrepreneur can do, and are usually a good relative indicator for comparison purposes. To see how this works, imagine you are a banker. You have two borrowers coming in for a possible loan; one is a long-term customer who has always paid his bills on time and has an established business. The other is a newcomer to town and his only asset is the pickup truck he drove into town with. Both are interested in starting a new restaurant. If you think about our formula for the nominal interest rate, as a banker you have a required real rate of return that you want, but it doesn’t change between borrowers. Likewise the inflation premium is the same, since both borrowers will be paying back their loans with the same inflated dollars. But do you think each borrower is equally likely to pay back? The risk premium is where you as a banker will make this assessment. Even if you agree that the 2nd borrower’s business plan is top-notch and you are impressed with his references and character, he simply doesn’t have the track record of your first borrower, your long-term customer. So you will only be willing to loan the 2nd borrower money at a higher interest rate. You will charge him a higher risk premium, which will be embedded in the interest rate. In this particular case, the variability of the return to the banker may range anywhere from none of the money paid back, to all of it paid back at the higher interest rate. In the same way, even if a firm is comparing two projects with internal funding (funding out of profits), they will discount the cash flows with differing interest rates based on the riskiness of the project. Each of the two investments’ riskiness will be assessed in terms of the variability of its CFs. The firm will make its best estimate as to the cash flow and then assign a higher risk premium to the project that is riskier (with more variable CFs). Yet another way this works is with fundamental stock analysis (we’ll review stock markets below). If an investor is considering purchasing shares of two companies, she will discount the expected cash flows (dividends) to arrive at a price she is willing to pay. For the interest rate, she will apply a higher discount rate to the dividends of the “riskier” company, in recognition of the higher variability in potential returns. Stock analysts calculate a firm’s beta (the variability of an individual stock’s return relative to that of the market) as a measure of risk. If a firm’s stock price varies exactly as the general market does, its beta = 1, if the stock price varies more than the stock market its beta is greater than 1, and if it varies less than the stock market its beta is less than one. If a stock’s beta is greater than one, it will have a higher risk premium applied in discounting its cash flows compared to a stock that mirrors the market (beta = 1). Beta: A measure of risk based on the variability of an individual stock’s return relative that of the overall stock market.