Evaluating risk-adjusted discount rates in forest investment decision making

Abstract

One approach to risk in investment evaluation is to discount expected cash flows with a single risk-adjusted discount rate. When emphasis is placed on total (as opposed to systematic) risk there are no a priori criteria guiding the proper selection of' the risk-adjusted discount rate. It is unlikely that a single rate will capture the risk differences between the investment alternatives considered.

This study evaluates risk-adjusted discount rates in the context of stand-level investment decisions. The investment setting is a non-diversified risk-averse individual facing mutually exclusive opportunities in forage hay, pine plantation, and mixed pine-hardwood management. These opportunities contrast differences in cash flow, objectives, capital requirement, and presumably risk. Risk-adjusted discount rate bias was defined as the tendency to incorrectly identify a suboptimal alternative as being the most preferred. The correct ranking and valuation of alternatives was conducted using an expected utility approach to risk. The scope of the analysis was to assess to what degree, if any, does risk-adjusted discount rate bias occur in an actual stand-level investment setting. Therefore, the numerical results in the analysis pertain to a case study example and are not general enough to make definitive conclusions about the overall riskiness of forestry and hay investments.

The potential for risk-adjusted discount rate bias was demonstrated in a hypothetical investment context. However, when risk was empirically estimated through simulation, risk-adjusted discount rate bias was less pronounced in the ranking of alternatives. Instead, the influential parameter was the risk-free discount rate. Based on an objective simulation of risk, which only accounted for historical variability in yields and prices, the estimated correct risk premiums in the discount rate were imperceptibly small, especially in the context of measurement error in specifying the risk-free discount rate. The implication is not that risk can be ignored, but that treating risk via the risk-adjusted discount rate approach is inadequate. More general approaches to risk are recommended, implying much research is still needed in this area.