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I am calculating the Net Present Value (NPV) for my investments. I used a higher discount rate for the more risky investments. However, the "Common pitfalls" section of the Net present value article on Wikipedia says this:

  • Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g., by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.

Questions:

  • Why can't I use a higher discount rate for valuing investments that are more risky?

  • I don't understand the bold text. In particular: "if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost". What does this mean?

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Why can't I use a higher discount rate for valuing investments that are more risky?

It doesn't say you can't, it just gives some drawbacks, and may not be as simple as adding an arbitrary risk premium. It's certainly common to use a discount rate from other investments of equivalent risk to calculate NPV. Determining "equivalent risk" may be difficult and may not be fully encapsulated by a discount factor, but it's not altogether wrong.

"if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost". What does this mean?

The reference to Monte-Carlo makes me think that the author is referring to a more probabilistic view of risk like Value At Risk (VaR). VaR tells you the maximum you can expect to lose with a certain probability (typically 95% or 99%). It's not saying that accounting for risk in the discount factor is wrong, only that it's not a complete view of risk. Every measure of risk (discount rate, IRR, VaR) has its strengths and weaknesses, and should be look at at parts of a whole rather than in isolation.

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The discount rate is the your gain in a risk-free alternative. It is independent from the risk of your investment.

I would take the uncertainty in future cash-flow into account by creating multiple scenarios with multiple probability level, and calculate with the expected value.

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