Determining the Generalized Discount Rate for Risky Projects

Lanlan Luo, Shou Chen () and Ziran Zou ()
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Lanlan Luo: Business School of Hunan University
Shou Chen: Business School of Hunan University
Ziran Zou: Business School of Hunan University

Environmental & Resource Economics, 2020, vol. 77, issue 1, No 6, 143-158

Abstract: Abstract It is widely recognized that the evaluation of risky projects critically depends on how the riskiness of future benefits is treated. Standard discounting theories are based on the assumption that risks that are uncorrelated with aggregate risk are diversified, so that projects’ idiosyncratic risk is not priced. However, this may not be true for long-term risky projects, such as those with persistent idiosyncratic shocks. In this study, we investigate the impact of both aggregate risk and nondiversifiable idiosyncratic risk on the discount rate for risky projects. We extend the generalized discount rate to the case of persistent shocks. A particular advantage of the generalized discount rate is that it can be applied in the setting of incomplete markets. We show that nondiversifiable idiosyncratic risk reduces the discount rate, and increases the present value of projects’ future uncertain benefits. We further apply our findings to the evaluation of emissions reduction projects.

Keywords: Generalized discount rate; Term structure; Idiosyncratic risk; Cost–benefit analysis; Emissions reduction projects (search for similar items in EconPapers)
JEL-codes: D61 G12 H43 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (3)

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DOI: 10.1007/s10640-020-00458-5

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