Abstract:
Traditionally, present worth is computed with a single interest rate. However, the real options literature includes examples where “first” costs are discounted using a continuous risk-free interest rate while later revenues are discounted using discrete market interest rates. This begs the questions of why, how common, and how important are these interest rate assumptions?
This paper analyzes real option articles in leading finance journals and The Engineering Economist to (1) establish the range of assumptions that have been used, (2) estimate their relative frequencies, and (3) illuminate the difference in approaches between finance and engineering economy. This paper also analyzes a realistic delay option example. Sensitivity analysis allows us to examine when and if the difference in interest rate assumptions leads to different recommendations and what aspects of the problem drive changes in those recommendations. In conclusion we make recommendations regarding the use of multiple discount rates for determining NPV.
