Question

What are the main reasons and concepts for a company to apply valuation theory to the application of risk management?

Answer 1

The main reason for a business to apply the valuation theory is the use of the risk adjusted discount rate.

The valuation theory applies the risk adjusted discount rate to discount the future expected cash flows and to arrive at the present value of the business. If the business has significant risk, the discount rate increases thereby reducing the present value in line with risk. On the other hand if the business risk is low, then the discount rate is reduced giving a higher present value.

The second main reason is the ease of use of the valuation theory. Instead of complex simulations and scenarios based methods, the valuation method gives us a simple and straightforward method of valuing a business.

The third main reason is the calculation of the net present value. If the offer rate to buy the business is lower than the present value of future cash flows, then it is a buy. In simple terms, if the Net Present Value is a positive, then it is recommended to buyout the business, else it is not.