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Law & Valuation
2.4.2 Valuing Certainty Equivalents

2.4.3 Adjusting Discount Rates

Another method for valuing future returns is to focus on the volatility of the expected return and adjust the discount rate to account for this volatility. (In this way the discount rate compensates for two financial elements -- volatility risk and time value of money.) In our example, if we concluded that our investment has similar risks to a one-year investment offering a 9.8% return, we could compute our investment's present value:

Return
Probability
Expected return
Present value
$5
33.33%
$1.67
$12
33.33%
$4.00
$20
33.33%
$6.67
Total
$12.33
$11.75/(1+.098) = $10.70

But this method depends on determining the return on "similar" investments. And to be precise we should figure out the comparable return (discount rate) for returns of different future periods. That is, there may be a different discount rate for expected returns in five years, compared to those in one year.

Risk-free Return

The discount rate you choose in computing the present value of an expected future return compensates for multiple factors:

  • time value of money (current spending power is more valuable than future spending power)
  • inflation risk (a unit of currency in the future may be worth less than today)
  • asset variability (future returns from the particular asset may not be as expected)

Student paper

How should courts identify an appropriate rate to determine the present value of deferred cash payments under a Chapter 13 individual reorganization plan? See Charles M. Sprinkle, What is the Appropriate “Market Rate” in Valuing a Creditor’s Claims in Individual Reorganization Plans?

 
2.4.2 Valuing Certainty Equivalents

©2003 Professor Alan R. Palmiter
This page was last updated on: March 16, 2004