The acceptance of risk is an integral part of business, as is the principle that the higher the risk, the higher the rate of return needs to be. The willingness to take risks of both a personal and a financial nature is one of the defining characteristics of the entrepreneurial decision-maker.

Interestingly, a 1999 study commissioned by PricewaterhouseCoopers concluded that whereas in continental Europe strategies are generally oriented towards avoiding and hedging risk, Anglo-American companies view risk as an opportunity, consciously accepting the responsibility of risk management as necessary to achieving their goals.

Successful decision-makers understand this. They take steps to ensure that the risks resulting from their decisions are measured, the likely consequences are clearly understood and the danger signals are identified. Avoidable risks are pinpointed and eliminated, and others are reduced. Such decision-makers also take a holistic view of risk, going beyond the direct financial perspective and actively managing risk as it affects the whole organisation.

Accepting that risks exist provides a starting point for other necessary actions. Foremost among these is the need to create the right climate for risk management. People should understand why control systems are needed. This requires communication and leadership so that standards and expectations are set and clearly understood.

Decide the discount factor: the percentage that will be deducted from each year’s cash flow. Determining this is central to the whole exercise. A higher discount factor will generate a lower overall valuation. Typically, two things influence the level of the discount factor. The first is the level of business risk. If the risk is high (and the investment is unlikely to meet its projections), the discount factor should also be high. Second, there is often a compromise between the cost of borrowed money (such as 5% interest) and the return expected by the investors (for example, 15%); in this case, the discount factor would be 10%. It may be desirable to select a range of discount factors, providing optimistic, realistic and worst-case scenarios.

Apply the discount factor to the net cash flow for each year of the projection and to the terminal value. The figures resulting from these calculations are the present value contribution of each year’s future cash flow; adding these values provides a total estimate for the value of the investment.