TABLE OF CONTENTS The traditional valuation tools, including the discounted cash flow (DCF) method and decision tree analysis (DTA), have been employed for several decades in valuation of projects. Although these tools have been effective for many applications, they pose certain challenges under specific conditions. The objective of this chapter is to discuss the challenges and address why a more sophisticated technique is needed. In order to recognize and appreciate the challenges, it is important first to understand risks and how they are accounted for in the DCF and DTA methods. Therefore, this chapter is divided into three major sections. The first section introduces the concept and definition of risk and types of risks; the second deals with the so-called discount rate dilemma, namely, what discount rates to use in DCF and DTA calculations to account for the risks related to the project under scrutiny; and the last section discusses the challenges of the traditional tools.
Business is basically about taking risks. The common notion is that the higher the risk one is willing to take, the higher the returns. But it is the possibility of higher returns, obviously not guaranteed higher returns. Risk, in a layperson s view, is entirely negative, but in business it includes both negative and positive outcomes. It relates to the variance of real outcomes around the expected outcome. The greater this variance, the higher the risk is perceived to be.
A banker would approve a loan only when he or she fully expects the borrower...
