Risk Discounting: The Fundamental Difference between the Real Option and Discounted Cash Flow Project Valuation Methods

Abstract

The real option valuation method is often presented as an alternative to the conventional discounted cash flow (DCF) approach because it is able to recognize additional project value due to the presence of management flexibility. However, these two valuation methods can be separated on a more fundamental level by their differences in risk discounting. Real option valuation applies the risk-adjustment to the source of uncertainty in the cash flow while the DCF method adjusts for risk at the aggregate level of net cash flow. This seemingly small difference is the reason why the real option method is able to differentiate between projects according to each project's unique risk characteristics while the conventional DCF approach cannot. This paper provides an overview of the real options and DCF valuation frameworks and discusses the differences in risk discounting that exist between the two methods. Using grade-school mathematics, this paper clearly demonstrates how, with real options, a unique project risk discount can be calculated which is directly linked to the project's unique risk profile. It also highlights why the DCF method fails in this regard and shows why a call to increase the Risk-Adjusted Discount Rate is an incomplete solution at best. Finally, a heap-leach project and satellite reserve development project are valued with both techniques and the difference in investment conclusions is explained in terms of the risk-discounting concepts discussed here.

Keywords: Project valuation, risk discounting, discounted cash flow, real options, asset pricing, capital budgeting

JEL Classification: G12, G31, Q00, Q30, Q40