A Glum Primer: How to Account for Risk with Uncertain Npvs

4 Pages Posted: 2 Jun 2017 Last revised: 15 Dec 2018

See all articles by Phillip E. Pfeifer

Phillip E. Pfeifer

University of Virginia - Darden School of Business

Samuel E. Bodily

University of Virginia - Darden School of Business

Manel Baucells

University of Virginia - Darden School of Business

Abstract

This note describes a method for adjusting uncertain future cash flows into a present certain equivalent. The use of net present value (NPV) to adjust a stream of future known cash flows into a single-value equivalent adjusted for the time value of money is common practice. The use of simulation to produce a risk profile of NPV values is also now common. While the expected net present value (ENPV) is often used to convert a risk profile of uncertain NPVs into a single-value equivalent, this approach ignores risk and the decision maker's attitude toward risk. Simply put, a 50% probability of receiving an NPV of $1 million is not as attractive as a 100% chance of receiving an NPV of $500,000. The general logarithmic utility model (GLUM) constructs a single certain equivalent from a risk profile (i.e., a “risk-adjusted NPV”) which goes beyond ENPV to incorporate risk aversion into the decision-making criterion. The simplicity and many attractive properties of the GLUM prompt us to suggest it as more attractive than other ways to adjust an NPV risk profile for risk.

Excerpt

UVA-QA-0849

Rev. Nov. 26, 2018

A GLUM Primer: How to Account for Risk with Uncertain NPVs

We use net present value (NPV) to convert a stream of future known cash flows into a single-value equivalent. The NPV tool uses a discount rate to correctly account for the time value of money. We often next use expected net present value (ENPV) to convert a risk profile of uncertain NPVs into a single-value equivalent. Although ENPV accounts for all possible NPVs and their relative likelihoods, it ignores risk and the decision-maker's attitude toward risk. Simply put, a 50% probability of receiving $ 1,000,000 is not as attractive as a 100% chance of receiving $ 500,000. This makes ENPV an incomplete decision-making criterion.

The purpose of this note is to describe the general logarithmic utility model (GLUM), which constructs a single-value equivalent from a risk profile. The resulting single-value equivalent is called a “present certain equivalent,” or “risk-adjusted NPV,” which goes beyond ENPV to incorporate risk aversion into the decision-making criterion. The simplicity and many attractive properties of the GLUM prompt us to suggest it as more attractive than other ways to adjust an NPV risk profile for risk.

How to Use the GLUM

. . .

Keywords: NPV, ENPV, general logarithmic utility model, GLUM, present certain equivalent, risk profile

Suggested Citation

Pfeifer, Phillip E. and Bodily, Samuel E. and Baucells, Manel, A Glum Primer: How to Account for Risk with Uncertain Npvs. Darden Case No. UVA-QA-0849. Available at SSRN: https://ssrn.com/abstract=2975189

Phillip E. Pfeifer (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4803 (Phone)

HOME PAGE: http://www.darden.virginia.edu/faculty/Pfeifer.htm

Samuel E. Bodily

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4813 (Phone)
434-293-7677 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/bodily.htm

Manel Baucells

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
0
Abstract Views
166
PlumX Metrics