Adjustments within discount rates to cater for uncertainty—Guidelines

David G. Carmichael

The Engineering Economist, 2017, vol. 62, issue 4, 322-335

Abstract: Deterministic discounted cash flow (DCF) analysis is a well-accepted technique in engineering appraisals. Common practice is to incorporate all uncertainty influences within a single variable—namely, the discount rate—which also represents the time value of money. Commentary already exists in the literature that such a practice is expedient but not rational and has shortcomings. This article examines the error involved in this practice and provides guidelines and precautions for using blanket or constant discount rates in dealing with uncertainties. It shows the adjustments necessary for any given investment scenario. This is done through establishing equivalence of the expected utility of deterministic and probabilistic present worth, allowing a rate adjustment to be calculated. Numerical studies look at the relationship or trends of this rate adjustment to the key analysis variables. Generally, it is found that the rate adjustment should be decreased as the timing of a cash flow's occurrence increases, increased as the variance of the cash flow increases, kept almost as an additive constant as the base rate increases, and increased as the investor's level of risk aversion increases. The article provides practitioner-friendly usable guidelines for adjusting rates, something that is unavailable elsewhere in the literature.

Date: 2017
References: Add references at CitEc
Citations:

Downloads: (external link)
http://hdl.handle.net/10.1080/0013791X.2016.1245376 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:uteexx:v:62:y:2017:i:4:p:322-335

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/UTEE20

DOI: 10.1080/0013791X.2016.1245376

Access Statistics for this article

The Engineering Economist is currently edited by Sarah Ryan

More articles in The Engineering Economist from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().