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Investing in Resilience

Investing in Resilience 2018-03-12T10:13:04+00:00

Multimillion dollar investments require a good understanding of the risks associated with both the revenue side and the cost side. Because of its simplicity, the net present value (NPV) technique is the most widely used method to evaluate long-term multimillion dollar investments. In the NPV method, all risks associated with a project are lumped into a single parameter (i.e., the risk premium) that is, the time value of money is adjusted to account for risk. However, because NPV results are very sensitive to the selection of the discount rate, this practice of selecting a discount rate based on heuristic arguments and rules of thumb introduces a time-bias effect that have led to significantly under- or over-valuing of future revenues and/or expenditures (or liabilities). Moreover, because risk and time are indeed independent variables, accounting for risk in this manner makes it difficult to take advantage of experts’ experience as it is difficult to establish a direct correlation between risk and discount rate.

A complementary valuation method that decouples the time value of money from the risk associated with a project can be used to evaluate the effect of investing in resilience. The method, termed decoupled net present value (DNPV), is simple and intuitive yet flexible, consistent, and robust (for more details visit www.dnpv.org). This bottom-up approach allows all technical experts associated with the project to identify all risks associated with it and then integrate these risks in the project valuation (i.e., it is endogenous to the project). More importantly, it allows the financial benefits of investing in resilience measures (and averting future losses) to be quantified. Our ability to understand the project’s financial and risk performance of a project allows us to provide clients with additional tools for their investment decisions. The classic NPV is used as a measure of the project financial performance whereas DNPV is used as a measure the project risk performance. A project is said to earn a return consistent with the risk of the project if DNPV>0 whereas it earns its cost of capital if NPV>0. Optimal investments are obtained when both the financial and risk performance measures are greater than zero.

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