Valuation of Cash Flows with Time-Varying Cessation Risk

Abstract

We extend the analytical framework of traditional DCF models to allow for the possibility of a time-varying cessation risk for cash flows. We first set out a parsimonious functional form for time-dependent survival probability of cash flows and then derive a closed-form solution for cessation risk-adjusted discount rates within a DCF model. Application of the model to a new data set, created for this paper, demonstrates that U.S. start-up firms face considerable risk of cessation, particularly during the first five years of their existence. This finding suggests that the time-varying discount rates that are appropriate to value them are considerably higher than those used in traditional DCF models.