Financial Management

26Risk, Uncertainty, and the Cost of Capital

Risk and uncertainty impact all projections about future performance that support everything from forecasts and plans to investment decisions and valuations. We will deal with uncertainty in this chapter in the form of discounting future cash flows. Risk and uncertainty are addressed, in part, in two fundamental financial principles: the time value of money and the cost of capital. Additional mechanisms to understand and deal with risk and uncertainty will be addressed in Chapters 28 and 29 covering capital investment decisions.

THE TIME VALUE OF MONEY

The time value of money (TVOM) is an important financial concept. Essentially, the TVOM recognizes that a dollar today is worth more than an expectation of receiving a dollar in the future. Several factors contribute to this:

• Inflation reduces the purchasing power in the future.
• Uncertainty reduces the value of future cash or income payments (you may never get paid in full).
• If you hold or invest a dollar, there is an “opportunity cost” (i.e., you are forgoing other opportunities to use that dollar). If you leave your savings in a bank savings account with very modest interest rates, you have passed on an opportunity to invest in a stock or bond with potentially higher returns. If a company invests in a project, it is passing on the opportunity of investing the capital in another project or financial security (or returning it to shareholders).

We will review the key aspects ...