One-size risk-adjusted discount rate does not fit all risky projects

Abstract

PurposeThe paper proposes using modified duration in calculating the proper risk-adjusted discount rate (RADR) to account for downside risk scenarios in capital budgeting.Design/methodology/approachThe paper shows how to use modified duration to summarize in a single number the bidimensional information about the inflows and terms in which they are charged in the use of the RADR. If a short modified duration characterizes the project, that is, the most relevant inflows are charged in short times, then discounting at RADR has mild effects on net present value (NPV). Else, if a long modified duration characterizes the project, discounting at RADR may have severe effects on NPV. The study proves that RADR's effectiveness increases with the project's modified duration.FindingsThe study builds a bridge between the regular NPV method used in academia and the RADR method used in the managerial context by identifying the proper RADR that leads the same NPV risk-adjustments, whichever method is used by including modified duration into the analysis.Practical implicationsThe results show how to select the proper RADR by reducing the subjectivity and increasing financial precision based on modified duration, thus providing an alternative to the norm. Simulations are used to make sensitivity analysis more effective and spotlight the main drivers in the risk-adjustments providing robust results.Originality/valueThis paper fulfils the gap between the RADR method and the expected net present value method by providing simple relations between the characteristic parameters.