A discount rate adjustment for calculation of expected net present values and internal rates of return of investments whose lives are uncertain

Abstract

Adjustments to the discount rate are commonly made in the capital budgeting process, as a means to compensate for uncertainty about future income streams. If the investment project's income level is relatively certain but its duration is a random variable, then a discount rate adjustment may be facilely derived, which has an explicit and intuitive interpretation in terms of the distribution parameter, when investment failure is characterized by an exponential process. To arrive at the expected present value of the investment, the riskless discount rate is shifted upward by this premium and the present value of the investment's income stream is calculated, in the conventional way, as though the failure rate were zero. In addition, the premium can be subtracted from the risklessly computed internal rate of return, in order to obtain an expected internal rate of return, when there is uncertainty about the investment's life.