Net Present Value Analysis of Projects Under Expected Utility

25 Pages Posted: 3 Apr 2018

See all articles by Manel Baucells

Manel Baucells

University of Virginia - Darden School of Business

Samuel E. Bodily

University of Virginia - Darden School of Business

Date Written: April 3, 2018

Abstract

The traditional decision-analytic approach to incorporate risk aversion into project evaluation is to calculate the expected utility of initial capital plus net present value. The choice of discount rate, and the convergence with the traditional finance approach, have always been a question. Our goal is to fill this gap. We adopt a standard continuous-time setup whereby the alternative to the project is the market for treasuries and stocks, and provide reasons to restrict preferences to generalized power or log utility. We find a convenient rate to discount portfolio capital (treasuries, stocks, and the project), which depends on market parameters and on the utility function. We also cater to practitioners, who discount the cash flows of the project, and ignore the market uncertainty. For them, we propose an adjusted discount rate that correctly compensate for the omission. The adjusted discount rate is lower than the beta-adjusted rate recommended in finance, and converges to the latter when the initial capital is large relative to the project, or the owner is risk neutral.

Suggested Citation

Baucells, Manel and Bodily, Samuel E., Net Present Value Analysis of Projects Under Expected Utility (April 3, 2018). Darden Business School Working Paper No. 3155192. Available at SSRN: https://ssrn.com/abstract=3155192 or http://dx.doi.org/10.2139/ssrn.3155192

Manel Baucells (Contact Author)

University of Virginia - Darden School of Business ( email )

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

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

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