- Elgar original reference
Edited by John Weiss and David Potts
John Weiss and Keith Ward Uncertainty about future project values is present in all projects and in practice is addressed with differing degrees of rigour. The theory underlying these adjustments has been known for a long time. In an uncertain world where decision takers are unconcerned about the level of risk (risk-neutrality) expected future effects must be estimated based on their probability of occurrence and a measure of project worth calculated at a discount rate that is unadjusted for risk. This is the standard assumption applied in the appraisal of many public sector projects. Alternatively, where risk is perceived as a cost by decision takers (risk-aversion), there are two possible approaches. In one approach, future expected effects are adjusted for risk by conversion to a certainty equivalent value.1 If this is done the normal unadjusted discount rate can be applied. In the other approach future effects are valued at their expected future value but the discount rate is adjusted upwards to incorporate risk. In other words, where decision takers place a cost on risk, either net benefits are adjusted downwards or the discount rate is raised. Theoretically the procedure of adjusting the discount rate upwards by a fixed margin to address risk is likely to be misleading since it will only be correct where uncertainty increases through time. In practice a majority of public sector appraisals adopt the expected value (or probabilityweighted) approach to risk, which has been greatly simplified by the advent of computer software packages. However, there are...
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