Decoupled NPV: A simple, improved method to value infrastructure investments

Despite its shortcomings, because of its simplicity, the net present value (NPV) technique (or its close relative, the internal rate of return) remains the valuation method most widely used by investors. In this method, all risks associated with a project are lumped into a single parameter (i.e. the risk premium) that is added to the risk-free interest rate to obtain a risk-adjusted discount rate; thus, in essence, the time value of money is adjusted for risk. However, because risk and time are two separate variables, accounting for risk in this manner can lead to substantial valuation errors, particularly for long-term investments which are typical for large infrastructure projects. In this paper, an alternative valuation method that decouples the time value of money from the risk associated with a project is presented. The proposed method, termed decoupled net present value (DNPV), is also simple yet flexible, consistent and robust. The method allows investors to integrate heuristic (i.e. experience based) techniques with sophisticated probabilistic and stochastic techniques to price the risk associated with the value of the asset created and/or the investment needed to create the asset. The proposed method results in a consistent valuation free from the problems typically associated with traditional net present value applications and, more importantly, allows a seamless integration of project risk assessment/management performed by technical experts into the project financial valuation.