Risk Reflection in Business Valuation Methodology

Abstract

This article is to investigate relevant and sophisti-cated problem concerned with risk reflection in business valuation methodology. The relevance and sophistication of risk reflection in business valuation methodology is affirmed by the discus-sions of scientists who analyse the problems of business valuation. Description, classification and valuation of risk within context of business valuation have several approaches in scientific literature. Presented classifica-tions of risk are various and include various types of risk and factors determining risk. Considering variety of risk classifications it is sug-gested risk’s classification based on decomposition of systematic (external) and unsystematic (internal) risks to the factors that have influence these kinds of risks. Factors of systematic risk are classified according to factors of macro environment and industry environment. Factors of unsystematic risk are divided into two groups: quantitative and qualitative factors. Classifica-tion based on approach of risk decomposition allows determining the factors of risk of various levels and also shows the connection between these factors and both systematic and unsystematic risks. The analysis of scientific literature shows that there is more than one approach to risk reflection in the busi-ness valuation methodology. Two alternative ways of risk reflection within the calculations of business value are mentioned in the works of different authors who re-search the problems of business valuation. The first one is related to risk’s reflection in the calculations of cash flow and the second one allows risk valuation in the discount rate. Although various definitions of discount rate are given in scientific literature most authors de-scribe it as rate of return used to transfer free cash flow into current value. Discount rate is the company’s fi-nancing source price which reflects time factor and risk in the calculation. According to this risk should be re-flected in discount rate calculations within context of business valuation. Risk valuation in the calculations of discount rate is based on discount rate decomposition to different level factors having influence on discount rate. First level factors are cost of equity and cost of debt; second level factors are debt rate of return and equity rate of return; third level factors are interest rate, profits tax, equity rate of return; fourth level factors are risk-free rate, risk premium for factors of macro environment, industry environment and internal environment. It is necessary to evaluate narrowness of risk- return models appliance in practice of business valuation in Lithuania while deter-mining factors of one of discount rate elements – equity rate of return. According to this narrowness it is sug-gested to calculate cost of equity by summing up securi-ties risk-free rate with expert’s determined premium for risk for factors of macro environment, industry envi-ronment and internal environment Scheme of discount rate factorial analysis within context of business valuation created by the authors of this article allows envisaging relation between discount rate and these factors, also research influence of these factors on discount rate and business value.