Discounting Under Uncertainty for a Private Investor

Many project evaluation and engineering economy books and manuals simply refer to rate of interest as the discount rate. This is because they are implicitly adopting the poor “perfect foresight” assumption.

When the fact of uncertainty is explicitly admitted in the discussion, economists generally recognize that:

1. the rate of interest and the rate of return (on equity) are no longer equal even in perfect markets,
2. the rate of return and not the rate of interest is the proper rate of discount.

Discounting by a rate of return is based on the principle of opportunity cost. Since no real investment in an economy can be undertaken without facing risks, cash flows of such investment should be discounted not by a riskless interest rate, but by their true opportunity cost. And “the opportunity cost of venture capital (equity investment) is what the funds would earn if invested as venture capital in some other firm” (Dorfman, p. 245). In the words of Lamberton: “the firm should discount its future income at an outside lending rate which differs from the borrowing rate. The lending rate could be measured in terms of the rate which the firm believes it could obtain by taking equity interests in other firms that appear to involve an element of risk about the same as that involved by further investment within the firm.” (Lamberton pp. 113-14).

Many economists choose to arrive at the rate of return by an indirect route called "the risk premium method”. In the face of uncertainty, they recommend obtaining the proper discount factor by adding a risk premium to the pure interest rate (Baumol, pp. 478-79; Prest and Turvey, p. 171; UNIDO, p. 114). I recommend, for two reasons to be given now, that this method be rejected even though it leads, when properly applied, to a rate of return which is the correct discount rate.

The first reason for rejecting the risk premium method is based on positive economic grounds. For that method begs the question of how the risk premium is to be determined and “comes with no explicit instructions which permit us to calculate the appropriate value of . .(the premium, which), must usually be estimated on the basis of some sort of judgement or intuition.” (Baumol, p. 479).

I wonder why Professor Baumol did not point out an objective way that permits the calculation of the appropriate “risk premium” and that shows at the same time how futile that method really is. The way is to select a premium just high enough to equate the pure rate of interest to the rate of return on a risky venture. Then why not use that rate of return as a discount factor in the first place! It is thus clear that the risk premium method, to be objectively applied, requires prior determination of the rate of return to which it is supposed to lead.

The second reason is ideological. The risk premium method may be used in effect as a face-saving device to avoid saying that the rate of interest is no longer valid for discounting under uncertainty. We should deny the defenders of interest this theoretical crutch.

In the next subsection we survey briefly the question of the “cost of capital” as it further corroborates the use of the rate of return as a discount rate.

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