Risk Adjusted Discount Rate
THE DIRECT D E T E R M I N A T I O N of RISK-ADJUSTED DISCOUNT RATES and LIABILITY BETA
RUSSELL E. BINGHAM T H E H A R T F O R D FINANCIAL SERVICES G R O U P
Table of Contents
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Subject Abstract 1. Summary 2. Total Return Model 3. After-Tax Discounting 4. Derivation of Risk-Adjusted Discount Rate and Liability Beta Figure l : Baseline Risk / Return Line vs Leverage 5. Liability Beta Figure 2: Equity vs Liability Beta Figure 3: Equity Beta vs Risk-Adjusted Discount Rate (After-Tax) 6. Underwriting Profit Margin Figure 4: Underwriting Profit Margin vs Loss Payout Figure 5: Underwriting Profit Margin vs Investment Yield Figure 6: Underwriting Profit Margin vs Market Risk Premium Figure 7: Underwriting Profit Margin vs Leverage 7. Conclusion Related Background Reference Reading Appendix - Example Exhibit I - Balance Sheet, Income, Cash Flow and Rates of Return Exhibit II - Net Present Value Without Risk Adjustment Exhibit I I I - Net Present Value With Risk Adjustment Exhibit IV - Myers-Cohn "Fair" Premium With After-Tax Discounting
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Abstract
The development of a complete financial structure including balance sheet, income and cash flow statements, coupled with conventional accounting and economic valuation rules, provides the foundation from which risk-adjusted discount rates and liability betas can be determined. Since liability betas cannot be measured directly, a shift in focus is proposed to one based on measures more readily available and better understood, such as cost of capital equity beta, leverage, etc. The risk-adjusted discount rate is shown as a function of these variables based on the developed financial structure and valuation framework.
The liability beta is then shown to follow as a consequence, also to be calculated as a function o f these same variables. The risk-adjusted discount rates that result are less than the risk-free rate and the liability betas are
RUSSELL E. BINGHAM T H E H A R T F O R D FINANCIAL SERVICES G R O U P
Table of Contents
Page 2 3 5 7 8 11 12 13 14 14 15 16 17 17
18
Subject Abstract 1. Summary 2. Total Return Model 3. After-Tax Discounting 4. Derivation of Risk-Adjusted Discount Rate and Liability Beta Figure l : Baseline Risk / Return Line vs Leverage 5. Liability Beta Figure 2: Equity vs Liability Beta Figure 3: Equity Beta vs Risk-Adjusted Discount Rate (After-Tax) 6. Underwriting Profit Margin Figure 4: Underwriting Profit Margin vs Loss Payout Figure 5: Underwriting Profit Margin vs Investment Yield Figure 6: Underwriting Profit Margin vs Market Risk Premium Figure 7: Underwriting Profit Margin vs Leverage 7. Conclusion Related Background Reference Reading Appendix - Example Exhibit I - Balance Sheet, Income, Cash Flow and Rates of Return Exhibit II - Net Present Value Without Risk Adjustment Exhibit I I I - Net Present Value With Risk Adjustment Exhibit IV - Myers-Cohn "Fair" Premium With After-Tax Discounting
19 20 23 24 25 27
Abstract
The development of a complete financial structure including balance sheet, income and cash flow statements, coupled with conventional accounting and economic valuation rules, provides the foundation from which risk-adjusted discount rates and liability betas can be determined. Since liability betas cannot be measured directly, a shift in focus is proposed to one based on measures more readily available and better understood, such as cost of capital equity beta, leverage, etc. The risk-adjusted discount rate is shown as a function of these variables based on the developed financial structure and valuation framework.
The liability beta is then shown to follow as a consequence, also to be calculated as a function o f these same variables. The risk-adjusted discount rates that result are less than the risk-free rate and the liability betas are