Join Jim Stice for an in-depth discussion in this video Risk and interest rates, part of Finance Foundations: Business Valuation.
- Here is the key point.…People typically need to be paid to get them to accept risk.…Why are you willing to accept a 0.1% return…on your savings account at the bank?…Because it's safe.…You don't have to worry about whether you're going…to get your money back, so you accept the low return.…But if you invest in our friend's online retailing business,…will you accept an expected return of 0.1%?…No, certainly not.…With the investment in our friend's business,…there is a chance that you'll make a lot of money…but also a chance that you will lose everything.…
That is risk, variability in potential future outcomes.…When valuing the cash flows expected…to come from a business,…we use a higher interest rate to compute…the present value of very risky future cash flows.…Interest rates to value the future cash flows…of large companies can be between 5% and 15%.…For small start-up companies…like our friend's online retailing business,…the increase risk involves,…meaning the appropriate interest rate is higher.…15 to 25% or even higher for a company…
Make sure to check out the Stice brothers' other accounting and finance courses to understand the other economic factors that impact your business.
- Using market, cost, and income approaches to business valuation
- Valuing homes
- Valuing companies by multiples
- Using price-to-sales ratios to value companies
- Using discounted cash-flow analysis to estimate value
- Valuing McDonald's as a case study