Why DNPV may be better than NPV
In an upcoming EduMine course on Risk Assessment, Decision Making, and the Management of Mine Geowaste, we write the following on the topic of Net Present Value (NPV):
Comparative Decision Analysis/Economic Safety Margin (CDA/ESM) provides an opportunity to apply Risk Based Decision Making to the alternative selection process and to explore how alternatives may differ in the long run, not only in their implementation and running costs, but also in their risk profile (upside and downside risks, i.e. opportunities and failures). The method is complex. There are many fine references on the web. Take a look at a few and see if you can apply them to your situations.
Not very informative, I am afraid.
So I phoned an old friend from twenty years ago. I knew that he knew more on the topic. He is David Espinoza. We worked together in Huntington Beach for Geosyntec. Now he is in Washington DC, still with Geosyntec.
He replied thus to my enquiries:
We recently created a new group that provides Capital, Assets & Transactions Advisory services (www.geosyntec-cat.com). It combines finance, risk and engineering. On the heels of this, we just got qualified to advise CALPERS (the $300-billion California Pension Fund) on infrastructure investments.
Also, there is quite an interest in what I have developed on risk quantification and infrastructure investment; I call it DNPV (Decoupled Net Present Value). The University of Liverpool (UK) is interested in funding several PhD students for 4 years to expand the ideas I developed. I am providing some links in case you are interested (the first one may be of interest to you since you always had a knack for language and you have a degree in law). I wrote all three.
Magnificent materials and perspectives I had not previously come across.
David also sent me a copy of one of his recent papers. Here is the abstract–contact me if you would like a copy.
Despite its shortcomings, because of its simplicity, the net present value (NPV) technique (or its close relative, the internal rate of return) remains the valuation method most widely used by investors. In this method, all risks associated with a project are lumped into a single parameter (i.e. the risk premium) that is added to the risk-free interest rate to obtain a risk-adjusted discount rate; thus, in essence, the time value of money is adjusted for risk. However, because risk and time are two separate variables, accounting for risk in this manner can lead to substantial valuation errors, particularly for long-term investments which are typical for large infrastructure projects. In this paper, an alternative valuation method that decouples the time value of money from the risk associated with a project is presented. The proposed method, termed decoupled net present value (DNPV), is also simple yet flexible, consistent and robust. The method allows investors to integrate heuristic (i.e. experience based) techniques with sophisticated probabilistic and stochastic techniques to price the risk associated with the value of the asset created and/or the investment needed to create the asset. The proposed method results in a consistent valuation free from the problems typically associated with traditional net present value applications and, more importantly, allows a seamless integration of project risk assessment/management performed by technical experts into the project financial valuation.
Wow! The paper is good and I hope one day to be called on to apply the method. Certainly I will invoke David’s help before I do and go off the tracks.