Risk-adjusted discount rates and the present value of risky nonconventional projects

Abstract

An appropriate risk adjustment technique applied to discount rate for evaluating stochastic negative cash flows is discussed. The proposed approach considers a future cash flow as a response to an investment or a borrowing rather than an independent cash flow. As discount rates applied to evaluate investments and borrowings have different meanings, the generalized net present value method is more appropriate to value cash flows with opposite signs. The given method uses two different rates: the finance rate is applied to discount positive present values (PVs) and the reinvestment rate – to discount negative PVs of a nonconventional project. It is shown that these rates are adjusted for risk relatively to their risk-free values in an opposite way. A universal relationship between risk penalty and risk premium is derived from the assumption that investment and borrowing risks are equal in their value.