e3value user manual, first release

7.4 The cost of risk

Suppose now we want to invest in a new venture, with considerably more risk than investing in state bonds. This increased risk is represented by a higher interest rate. In addition, the interest rate is also affected by cost of capital , since most companies must do some work to find the money to do the investment. High risk and high cost of capital are reflected in a high interest rate used for discounted net present value computations.

Suppose we value our risk at 20%. Using this percentage, the net cash flows generated a few years from now discount to a smaller net present value, as shown in table 7.3. With this amount of risk, the investment seems not to be such a good idea, since the investment results in a negative DNPC. For an investment with risk valued at 20% to be profitable, yearly net revenue should have been much greater.

Table 7.3:Calculation of discounted net present cash value over a series of time periods using 20% interest





Period

Revenues

Expenses

Investments

DNPC











0

1,000

-1,000






1

500

100

333.33






2

500

100

277.78






3

500

100

231.48











Total

-157.41






A frequent mistake while calculating the DNPC is to include depreciation costs [3]. However, depreciation costs do not lead to direct expenses. Rather, the upfront investment for which depreciation cost are made has already been taking into account while doing a DNPC calculation, so considering depreciation costs also, would lead to double counting.

Finally, it is important to understand a few assumptions while calculating net present discounted cash flows. First, the cash (revenues and expenses) should directly relate to the investment made.

Second, the calculation supposes that positive results of a contract period in a time series can be invested with same interest rate, as was used for the calculation.

Third, the calculation supposes that cash flows are only occurring at specific points in time, namely at the end of each contract period. Obviously, that is not always the case in real-life, but a simplification is made here to allow for easy calculation.