Additional Methods for Dealing with Uncertainty in Project Evaluation

The first implication of uncertainty for discounting is to make the rate of interest and the rate of return distinct and different, with the latter rate and not the former expressing the true opportunity cost of real investment. This has been the main conclusion of the last two subsections — 3 and 4.

Different approaches have been proposed to deal with uncertainty in project evaluation, with the following approaches rather widely discussed:

1. Discounting for risk, or the risk premium method.
2. The finite horizon or payback period method.
3. The conservative forecast method.
4. Professor G. Shackle approach.
5. The probability theory approach.
6. Sensitivity analysis.
7. Neumann-Morgenstern utility approach.

We propose now to consider briefly the relationship between these approaches to uncertainty on the one hand and the question of discounting on the other.

Several scholars including Professors Baumol, Prest and Turvey (p. 171) and Bromwich present the above approaches as alternative ways for dealing with uncertainty. It is not quite correct in our opinion to view all the above methods as alternatives. The reasons are as follows:

Once uncertainty is introduced, two consequences follow. The first, which is external to the project, is that the true opportunity cost of resources used by the project becomes the rate of return on other equally risky projects. To take care of this consequence, one must discount by a rate of return, i.e. must use method (a).

The other consequence, which is internal or specific to the project, is that the cash flow of each future period is no longer a single number held with certainty, but rather a spectrum of numbers, each with a given probability. Methods (b) to (g) above are meant to take care of this second consequence of uncertainty and should be viewed as alternatives to one another and not as alternatives to method (a).

We may say in conclusion that to deal properly with uncertainty, two things or methods must be applied in project evaluation:

• A rate of return (or the equivalent risk premium method) should be used in discounting, to reflect properly the true opportunity cost of project cash flows.
• And in addition, one of methods (b) to (f) should also be applied to reflect the variability or stochastic nature of project cash flows.

Source: Fiscal Policy and Resource Allocation in Islam, Ziauddin Ahmed, Munawar Iqbal and M. Fahim Khan. Republished with permission.