The Discount Rate for Investment Analysis Applying Expected Utility

Abstract

In decision analysis, expected utility of discounted cash flows is the traditional approach to incorporate risk aversion into the evaluation of a project. The choice of discount rate as well as the convergence with the beta-adjusted approach from finance have always been in question. To address this gap, we adopt a risk-sharing setup in which investors have both treasuries and the stock market as alternatives to the project. For a full utility analysis of all the investor’s capital, we provide a unique discount rate that allows setting the horizon at the termination of the project. For a traditional analyst who conducts expected utility of discounted cash flows and ignores the capital not allocated to the project, we recommend an adjusted discount rate that compensates for double-counting the systematic risk.