Explore BrainMass

Reliable estimation of appropriate discount rate, cash flows

I would agree that despite the advantages offered by NPV over alternative investment appraisal methods, there appear to be some practical issues such as the reliable estimation of an appropriate discount rate, as well as amount and timing of cash flows.

The estimation of appropriate interest rate has to consider various risk factors associated with an investment project. Can anyone suggest a technique that can be used to estimate risk premium?

Solution Preview

Here are two ideas (there are certainly more):

1. Expected Cash Flows

You can develop a range of cash flows possibilities and then the probability of each. For instance:

High $100,000 10% likely
Most likely $80,000 70% likely
Low $30,000 20% likely

You can then multiply these out to get an "expected cash flow" that blends the three potential levels of return.

High $10,000
Most likely 56,000
Low $6,000
Total $72,000

This is a way to "weight"? the future cash flows for upside opportunity and downside risk. If you use this type of process, you use the same discount rate across projects and the $72,000 would be the cash flow used instead of using the most likely cash flow of $80,000. The ...

Solution Summary

Your tutorial is 443 words plus three references. Two ideas are mentioned and an example from a real firm is given.