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Determining the Generalized Discount Rate for Risky Projects

Author

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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)

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.

Suggested Citation

  • Lanlan Luo & Shou Chen & Ziran Zou, 2020. "Determining the Generalized Discount Rate for Risky Projects," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 77(1), pages 143-158, September.
    • Handle: RePEc:kap:enreec:v:77:y:2020:i:1:d:10.1007_s10640-020-00458-5
    DOI: 10.1007/s10640-020-00458-5
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    References listed on IDEAS

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    Cited by:

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    3. Antonio Nesticò & Gabriella Maselli & Patrizia Ghisellini & Sergio Ulgiati, 2023. "A Dual Probabilistic Discounting Approach to Assess Economic and Environmental Impacts," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 85(1), pages 239-265, May.

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    More about this item

    Keywords

    Generalized discount rate; Term structure; Idiosyncratic risk; Cost–benefit analysis; Emissions reduction projects;
    All these keywords.

    JEL classification:

    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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