A Binary Model of Discounting Cash Flows to Correct Risk Assessment for Real Assets Evaluation
Discounting cash flows at the present stage of development of financial science is the basis of most financial calculations. However, the current practice of applying this method, taking into account risks in the discount rate in the form of a risk premium to the magnitude of the required return, is more suitable for the valuation of financial assets since they generate only one type of cash flow (inflows). In the case of real assets that generate both inflows and outflows, the use of a single discount rate, including a risk premium, leads to inadequate accounting for the risks of increasing outflows relative to their predicted value (risks of the second kind). To eliminate this drawback, this article proposes a binary cash flow discounting model that involves the use of two discount rates (separately for inflows and for outflows) determined on the basis of the yield required for this asset. The proposed model allows one to correctly take into account the risks of both the first and second kind and calculate the range of possible values of the net present value of the asset being evaluated. As shown in this article on the example of evaluating investment projects, when evaluating real assets, there is a significant difference between the net present value determined by the traditional approach to discounting cash flows using the required yield as a single discount rate for both inflows and outflows and the value of the net present value determined on the basis of the proposed binary model with separate consideration of the risks of the first and second kind at two different rates of discounting. The difference in valuation results is most pronounced for real assets that generate extraordinary cash flows. Differences arise due to the correct consideration of the risk of the second kind in the proposed method, which makes it possible to recommend it for use in the framework of the discounted cash flow method when evaluating real assets. It seems that this will provide an opportunity to achieve the maximum reasonableness of valuation of assets of this type and will improve the quality of management decisions made on the basis of the discounted cash flow method.