Decide How Much Cash Flow Risk to Take On  63
Decide How Much Cash Flow Risk to Take On
Now let’s turn to cash flow risk. When we talk about total cash flow risk, 
we mean the uncertainty that a company faces about its future cash flows, 
whether for the company as a whole, a business unit, or a single project. Fi-
nance theory provides guidance on pricing the nondiversifiable part of cash 
flow risk in the cost of capital. In theory, a company should take on all proj-
ects or growth opportunities that have positive expected values even if there 
is high likelihood of failure, as long as the project is small enough that fail-
ure will not put the company in financial distress. In practice, we’ve found 
that companies overweight the impact of losses from smaller projects, thereby 
missing value creation opportunities.
For instance, how should a company think through whether to undertake 
a project—let’s call it project A—with a 60 percent chance of earning $8,000, 
a 40 percent chance of losing $2,000, and an expected value of $4,000? Theory 
says to take on all projects with a positive expected value, regardless of the 
upside-versus-downside risk. A company is likely to have many small proj-
ects like this example, so for small projects, it should take on all projects with 
positive expected value, regardless of risk.
But what if the company instead has one large project where the downside 
possibility would bankrupt the company? Consider an electric power com-
pany with the opportunity to build a nuclear power facility for $15 billion (a 
realistic amount for a facility with two reactors). Suppose the company has 
$25 billion in existing debt and $25 billion in equity market capitalization. If 
the plant is successfully constructed and brought on line, there is an 80 percent 
EXHIBIT 4.3  Example of Equivalent Risk Premiums for Different Probability Levels of 
Failure
  Risk premium, %
Size of cash flow reduction, %
20
40
60
80
100
Probability of 
lower cash flow, 
%
10
0.1
0.2
0.4
0.5
0.7
20
0.2
0.5
0.8
1.1
1.5
30
0.4
0.8
1.3
1.9
2.6
40
0.5
1.1
1.9
2.8
4.0
50
0.7
1.5
2.6
4.0
6.0
A 1.5% risk premium is required, 
assuming even odds that an invest-
ment will lose 40% of its value
Note: This particular example is for a company with an indefinite life, assuming a smooth cash flow profile, 8% weighted average cost of capital, and 2% terminal 
growth. The cost of capital adjustments would be larger for a project with a short life.
Source: R. Davis, M. Goedhart, and T. Koller, “Avoiding a Risk Premium That Unnecessarily Kills Your Project,” McKinsey Quarterly (August 2012).