16 - When using discounted cash flow analysis to value an...

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When using discounted cash flow analysis to value an asset, explain why it is important to measure the risk of the asset and to associate an expected return with that risk measure. The procedure for valuing a risky asset involves three basic steps: (1) determining the asset’s expected cash flows, (2) choosing a discount rate that reflects the asset’s risk, and (3) calculating the present value. Finance professionals apply these three steps, known as discounted cash flow (DCF) analysis, to value a wide range of real and financial assets. The discounted cash flow approach is theoretically the most appropriate valuation approach. This method is used to value assets on the basis of the concepts of the time value of money. The value of the assets depends on the expected future cash flow and discount rate. As we are dealing with future cash flows, we have to consider the risk element because of the vagueness of future and to avoid losses. The discount rate depends on the risk of expected cash flows (i.e. uncertainty of future cash flows).
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