Home  Journals  Finance and Credit  28(364) – 2009 July

Cash Outflows and the Risk Premium

Available online: 17 September 2009

Subject Heading: Risks of management

JEL Classification: 

Authoritative finance textbooks and practical guidelines recommend discounting of the cash outflows by means of positive risk premium. However this method leads to paradoxical results increasing the value of projects with greater uncertainty in cash outflows. The paper revisits the grounds and principles of discounting both positive and negative cash flows within the portfolio theory framework. It proves that from the isolated investor standpoint and in the absence of hedging possibilities the cash inflows require positive risk premium while the cash outflows require negative risk premium. But the market value of cash flows involves the logic of portfolio theory that considers any cash flow according to its correlation with the market returns. Then both cash inflows and cash outflows may be discounted using either positive or negative risk premium depending on their covariance with the market. This implies that evaluation of the investment projects requires separated discounting of the cash inflows and cash outflows using specific discount rates properly adjusted for their risks. Alternatively one should deliberately determine the risk profile of the net cash flow and find the adequate risk premium.

Keywords: risky cash outflows, risk-adjusted discount rate, risk premium, CAPM, portfolio theory, capital budgeting, project evaluation

View all articles of issue

ISSN 2311-8709 (Online)
ISSN 2071-4688 (Print)

Journal current issue

Vol. 30, Iss. 4 April 2024

Archive