Deterministic discounting of risky cash-flows

Abstract

A model to value risky cash-flows through discounting at deterministic rates is presented. The analysis mainly concerns with the valuation of project’s levered cash-flows under default risky debt and general tax shield assumptions. Deterministic unlevered and levered rates as well as a deterministic Weighted Average Cost of Capital (dWACC) are defined and the relevant relationships among them are derived. The model allows to account for the risk of cash-flows in a proper way and produce exact results as in the stochastic discounting method. To illustrate the model, a numerical example about the evaluation of a two-period investment project with default risky debt is provided. The proposed approach is general and represents a first step toward a bridge between stochastic models for capital budgeting and more traditional capital budgeting techniques based on discounted cash-flow analysis.

Mathematics Subject Classification: G31; G32; G33