Risk Adjusted Discount Rates Research Articles

Assessment of uncertain returns from investment in short rotation coppice using risk adjusted discount rates

The increasing demand for renewable energy resources increases interest in the use of short rotation coppice (SRC) as alternative land use activity. The high uncertainty attached to returns from SRC is one of the key adoption barriers to farmers. One possibility to account for the role in investment assessments is the use of project specific risk adjusted discount rates (RADR). In this article, we revisit the theoretical background of RADR and illustrate different assumptions using an example of poplar based SRC. Time-invariant RADR used in the current literature on SRC assessment are found to over-emphasize the role of risk for project assessment and usually give to little weights to returns in future periods, which are of particular relevance for long-term investments in SRC. Thus, the use of time invariant RADR is found to lead to biased recommendations towards the attractiveness of SRC and optimal policy support.

Revisiting Modern Discounting of Risky Cash Flows: Imbedding Uncertainty Resolution Functions into Risk-Adjusted Discount Rates and Certainty Equivalent Factors (Revised)

The paper revisits the prevailing RADR-based approach to cash flows valuation, indicates its restrictions and failures and suggests flexible methodology of discounting cash flows by means of certainty equivalents with implied instantaneous measure of risk consistent with specific uncertainty resolution function. The RADR discounting techniques do not allow estimate values of risky initial cash outflows or differed nonrecurring cash flows with known standard deviation or more sophisticated measure of risk, since they use periodic measure of risk according to CAPM, its modifications or ex-ante approach. However that is not an insolvable problem, but a restriction of RADR approach. The Certainty Equivalents approach to discounting is easily made consistent with the basic assumptions of RADR and may be fine-tuned to incorporate Equity Risk Premium as a basis for CEQ factors and when properly applied provides the same results as RADR-based discounting, meanwhile overcoming the above-mentioned shortcoming. However the most hard critics of RADR concern the fact that it implicitly produces rigid pattern of risk increasing over time, which is a special case without sufficient evidence to be overwhelming in practice. Particularly, the paper demonstrates that for a remote lottery cash flow there would be instantaneous standard deviation at the moment of payment, which is hardly possible to convert to periodic standard deviation and the discounting at a RADR is surely a mistake, since the risk of such cash flow is fixed over time. This is an extreme example of cash flow with specific uncertainty resolution pattern for which RADR-based discounting is inconsistent and provided strongly distorted results. The paper also presents the formula to calculate RADR-implied standard deviation and finds it being two times higher than the standard deviation of identical cash flows explicitly expressed by Wiener process, i.e. square root of time. Suggested methodology addresses using the arbitrary Uncertainty Resolution function to express risk at a given moment, for instance such as Wiener stochastic process. It’s shown how to embed the Uncertainty Resolution into Certainty Equivalents Method of discounting and thus have a possibility to evaluate cash flows according to their explicit risk pattern. The paper also proves the Propositions for discounting cash flows with different time-remote risk patterns. Specifically it substantiates the recursive algorithm to CE-based valuations and differentiates the natural risk of cash flows and risk of future revaluation of current estimates, which is jointly presented in CAPM.

An entropy‐based financial decision support system (e‐FDSS) for project analysis in construction SMEs

Uncertainty contributes a major part in the accuracy of a decision‐making process while its inconsistency is always difficult to be solved by existing decision‐making tools. Entropy has been proved to be useful to evaluate the inconsistency of uncertainty among different respondents. The study demonstrates an entropy‐based financial decision support system called e‐FDSS. This integrated system provides decision support to evaluate attributes (funding options and multiple risks) available in projects. Fuzzy logic theory is included in the system to deal with the qualitative aspect of these options and risks. An adaptive genetic algorithm (AGA) is also employed to solve the decision algorithm in the system in order to provide optimal and consistent rates to these attributes. Seven simplified and parallel projects from a Hong Kong construction small and medium enterprise (SME) were assessed to evaluate the system. The result shows that the system calculates risk adjusted discount rates (RADR) of projects in an objective way. These rates discount project cash flow impartially. Inconsistency of uncertainty is also successfully evaluated by the use of the entropy method. Finally, the system identifies the favourable funding options that are managed by a scheme called SME Loan Guarantee Scheme (SGS). Based on these results, resource allocation could then be optimized and the best time to start a new project could also be identified throughout the overall project life cycle.

A Brief Inventory of Behavioral Influences on the Subjective Risk Adjusted Discount Rates in Project Appraisal

Behavioral finance has emerged as a new paradigm in financial economics. It deals primarily with the influences of psychology on market finance and with market inefficiencies. The field of psychology, already very present in organizational psychology and decision-making, is slowly opening up applications in corporate financial decisions and more specifically in corporate finance techniques. Among these corporate finance decisions is the project evaluation decision or the investment decision. This is based on first calculating expectations and risk estimates and then making a decision. This paper looks at how psychology can influence on the calculation of subjective risk estimates which are used to evaluate projects. We break down the risk factors used in project finance as the real time value of money, perceptions of inflation, market risk and Beta , financial risk and firm-specific risk and study some psychological factors which can influence each of these and why these may be important. The psychological factors we study in this paper include patience and impatience, optimism and pessimism, the notion of time in different cultures, inter-temporal differences/ dynamic inconsistency, inner tempo, achievement orientation, past or future orientation, addiction, frequency of evaluations, horizon / myopia, money illusion, loss aversion, values and lifestyles, agency problems,organizational decentralization, adverse selection, limited liability, venture capital firms, qualitative projects, example human capital, familiarity bias, confidence and hubris.

Arbitrage-Free Valuation of Investment Projects using Risk-Adjusted Discount Rates

This short note discusses the link between the certainty equivalent approach of modern asset pricing theory and the cost of capital approach in DCF-models in a capital market model. Therefore we distinguish two notions of cost of capital: (a) risk-adjusted discount rates for a particular cash flow and (b) risk-adjusted returns of the project. In order to account for the flow of information both types are defined with respect to the valuation date.

Risk‐Adjusted Discount Rates and Projects of Unequal Lives

When evaluating mutually exclusive projects of unequal lives and with differing risk, standard approaches such as the constant chain of replacement, lowest common multiple and equivalent annual value techniques are usually applied. In using these techniques to rank projects, a critical issue is the manner in which uncertainty in the cashflows is resolved through time. We explore the applicability of net present value techniques to the problem of valuing assets with unequal lives, emphasising the use of equivalent annual value and lowest common multiple methods, and the correct choice of discount rate. Our results have direct application to practical capital budgeting problems such as choosing the optimum lifespan for a single asset, choosing between assets with different lifespans, and deciding whether to “run an asset for another year”.

Risk analysis in investment appraisal based on the Monte Carlo simulation technique by A. Hacura, M. Jadamus-Hacura and A. Kocot

Comment on Eur. Phys. J. B 20, 551 (2001) Since Hertz major work on investment appraisal using the Monte Carlo Simulation technique, the so called “Risk Analysis” has become a standard tool for supporting investment decisions [1,2]. A main problem in investment appraisal is to consider and specify the risk of investment projects in an appropriate way, for enabling consistent project evaluation. In calculating a risky project's net present value (NPV) the major difficulty is to quantify the project's risk for quantifying an appropriate risk adjusted discount rate (RADR). Theoretically not founded risk adjusted discount rates face a lot of critique. Furthermore it is discussed that the incorporation of a constant risk factor into the discount rate makes a certain assumption about the resolution of uncertainty over time [3] and finally that a single net present value could not in general reflect risk properly. Especially in consequence of the last point the proponents of simulation argue that a whole distribution of net present values shows a project's risk better than a single number. In the special issue “Econophysics” of this journal Hacura et al. tried to describe the methodology and use of Monte Carlo Simulation in investment appraisal [4]. The purpose of this comment is to point out three fundamental flaws in that article.

Investment Analysis of Agri-Food Ventures: What Risk Premia are Appropriate? The Silence of the Literature

Financial principles of project investment analysis deal with the cost and benefit flows over time. Invariably, the correct future cash flows and exact risks are unknown. The agricultural academic literature devotes substantial energy to discussing the estimation of the cash flows but it is relatively silent on applied estimation of risk. Empirical studies on agri-food ventures have made little or no attempt to estimate appropriate risk adjusted discount rates or other risk measures. Choice of discount rate has been arbitrary. Thus little guidance has been given to practitioners analysing agri-food investments as to the appropriate risk adjusted discounts rates. The Capital Market Line provides a relatively straightforward way to calculate risk premiums for project investments by non-diversified investors. These risk premiums can then be used in Net Present Value investment analysis.

Integrating financial theory and methods in electricity resource planning

Decision makers throughout the world are introducing risk and market forces in the electric power industry to lower costs and improve services. Incentive based regulation (IBR), which replaces cost of service ratemaking with an approach that divorces costs from revenues, exposes the utility to the risk of profits or losses depending on their performance. Regulators also are allowing for competition within the industry, most notably in the wholesale market and possibly in the retail market. Two financial approaches that incorporate risk in resource planning are evaluated: risk adjusted discount rates (RADR) and options theory (OT). These two complementary approaches are an improvement over the standard present value revenue requirement (PVRR). However, each method has some important limitations. By correctly using RADR and OT and understanding their limitations, decision makers can improve their ability to value risk properly in power plant projects and integrated resource plans.

The Determination of Risk Adjusted Discount Rates for Private Sector Forestry Investment

The Determination of Risk Adjusted Discount Rates for Private Sector Forestry Investment

The Investment Decision: Estimation Risk and Risk Adjusted Discount Rates

i All capital budgeting decisions are made in an environment with estimation risk (or parameter uncertainty), simply because the correct project cash flows and risk adjusted discount rate (RADR) are unknown to the decision maker. The textbook literature is, however, largely silent on the subject of estimation risk in the RADR. Further, empirical studies of capital budgeting practices provide no hard evidence about how managers' decisions take into account estimation risk in the RADR. Here the impact of estimation risk in the RADR on estimates of project present values is examined. Two methods are presented for dealing with estimation risk in the RADR. The empirical survey literature provides only inferential evidence on how managers respond to estimation risk in the RADR. For example, it is known that most firms use discounted cash flow techniques and risk adjusted discount rates, sometimes in tandem with other evaluation methods such as payback (see Hodder [10] for a recent summary of the survey evidence). But it is not known if, or how, managers use these tools to account for estimation risk. Before making decisions, managers scale down estimates to compensate for perceived biases (Pruitt and Gitman [16] and Statman and Tyebjee [20]), but is this behavior an adjustment for estimation risk related bias or for other sources of bias

ON THE NEGATIVE RISK PREMIUM FOR RISK ADJUSTED DISCOUNT RATES

Journal of Business Finance & AccountingVolume 7, Issue 3 p. 427-436 ON THE NEGATIVE RISK PREMIUM FOR RISK ADJUSTED DISCOUNT RATES R.H. Berry, R.H. Berry The authors are respectively, lecturer and Senior Lecturer in the School of Industrial and Business Studies at the University of Warwick.Search for more papers by this authorR.G. Dyson, R.G. Dyson The authors are respectively, lecturer and Senior Lecturer in the School of Industrial and Business Studies at the University of Warwick.Search for more papers by this author R.H. Berry, R.H. Berry The authors are respectively, lecturer and Senior Lecturer in the School of Industrial and Business Studies at the University of Warwick.Search for more papers by this authorR.G. Dyson, R.G. Dyson The authors are respectively, lecturer and Senior Lecturer in the School of Industrial and Business Studies at the University of Warwick.Search for more papers by this author First published: September 1980 https://doi.org/10.1111/j.1468-5957.1980.tb00211.xCitations: 20 AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinked InRedditWechat Citing Literature Volume7, Issue3September 1980Pages 427-436 RelatedInformation

Some Observations on Risk-Adjusted Discount Rates: A Comment

Some Observations on Risk-Adjusted Discount Rates: A Comment

CONCEPTUAL PROBLEMS IN THE USE OF RISK‐ADJUSTED DISCOUNT RATES WITH DISAGGREGATED CASH FLOWS

Journal of Business Finance & AccountingVolume 5, Issue 4 p. 281-293 CONCEPTUAL PROBLEMS IN THE USE OF RISK-ADJUSTED DISCOUNT RATES WITH DISAGGREGATED CASH FLOWS BERNHARD SCHWAB, BERNHARD SCHWAB The author is Professor of Finance at the University of British Columbia. Search for more papers by this author BERNHARD SCHWAB, BERNHARD SCHWAB The author is Professor of Finance at the University of British Columbia. Search for more papers by this author First published: December 1978 https://doi.org/10.1111/j.1468-5957.1978.tb01053.xCitations: 11 AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinkedInRedditWechat Citing Literature Volume5, Issue4December 1978Pages 281-293 RelatedInformation

Some Observations on Risk-Adjusted Discount Rates

The Journal of FinanceVolume 32, Issue 4 p. 1331-1337 Note SOME OBSERVATIONS ON RISK-ADJUSTED DISCOUNT RATES Wilbur G. Lewellen, Wilbur G. LewellenProfessor of Management, Purdue University.Search for more papers by this author Wilbur G. Lewellen, Wilbur G. LewellenProfessor of Management, Purdue University.Search for more papers by this author First published: September 1977 https://doi.org/10.1111/j.1540-6261.1977.tb03331.xCitations: 24 Read the full textAboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Citing Literature Volume32, Issue4September 1977Pages 1331-1337 RelatedInformation

Conceptual Problems in the Use of Risk-Adjusted Discount Rates

Conceptual Problems in the Use of Risk-Adjusted Discount Rates