How does operational risk affect DCF analysis?

Higher operational risk is associated with increased uncertainty and potential for financial losses due to failures in internal processes, systems, or people. In the context of discounted cash flow (DCF) analysis, this uncertainty needs to be accounted for when determining the appropriate discount rate.

The discount rate reflects the risk associated with projected cash flows. When operational risk increases, investors typically demand a higher return on their investment to compensate for this additional risk. As a result, a higher discount rate is applied to the projected cash flows in the DCF model to reflect the likelihood that these cash flows may not materialize as expected due to operational challenges.

In summary, the relationship between higher operational risk and the increase in the discount rate in DCF analysis highlights the importance of accurately assessing operational risks when evaluating the present value of expected future cash flows. This adjustment ensures that the financial analysis aligns with the risk profile of the business being evaluated.