DNPV: a valuation methodology for infrastructure and Capital investments consistent with prospect theory

Abstract

Traditional valuation methods such as net present value (NPV) utilize increased discount rates to account for risk, in the process introducing a time bias effect that promotes short-termism. Application of NPV often discourages much needed infrastructure projects that require large capital investments yet are slow to generate positive cashflows. NPV also downplays the significance of future liabilities and can lead to risk misallocation amongst investment partners and stakeholders. The decoupled net present value (DNPV) method introduces the risk-as-a-cost concept that prices the risk of obtaining lower-than-expected cashflows and thus represents investors’ compensation for bearing such risks. Capturing the loss-aversion attitudes described by prospect theory, DNPV provides a transparent and consistent valuation framework for long-term investments by: (i) calculating expected values of cashflow components using their probability characterizations, (ii) defining the cost of risk (market and non-market) as the expected downside value, (iii) subtracting/adding the cost of risk from/to expected revenues/expenditures, and (iv) discounting the results using risk-free rates. DNPV’s power is illustrated by re-analyzing a 42-year toll-road concession initially evaluated using NPV and real options. The case study shows how explicit risk quantifications could be used to better structure the concession and reallocate risks among stakeholders.