Business Risk Type

Models of Risk and Return

Aswath Damodaran

Aswath Damodaran

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First Principles

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Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

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Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Objective: Maximize the Value of the Firm

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Aswath Damodaran

The notion of a benchmark

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Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A simple representation of the hurdle rate is as follows: Hurdle rate = Riskless Rate + Risk Premium

• Riskless rate is what you would make on a riskless investment • Risk Premium is an increasing function of the riskiness of the project

Aswath Damodaran

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Basic Questions of Risk & Return Model

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How do you measure risk? How do you translate this risk measure into a risk premium?

Aswath Damodaran

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What is Risk?

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Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”. The Chinese symbols for risk, reproduced below, give a much better description of risk

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The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

Aswath Damodaran

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The Capital...