In the MBA Applied Quantitative Finance program at Nürtingen-Geislingen University (HfWU), we discuss current topics in corporate valuation. A student asked how negative cash flows should be discounted. I am pleased to summarize the results of our discussion for you.
In corporate valuation and capital budgeting, the risk-adjusted discount rate method is frequently used: uncertain cash flows are discounted using a risk-adjusted discount rate. This works well – as long as the cash flows are positive.
A higher discount rate reduces the present value of a cash flow. For positive cash flows, this is intuitively correct: more risk → lower value.
With negative cash flows, however, the opposite occurs:
A higher rate “reduces” the negative present value. Formally, this means that an uncertain negative cash flow carries less weight than a certain negative cash flow.
This is mathematically consistent – but economically questionable.
Risk does not only mean “chance of better outcomes,” but also “danger of higher losses.” An uncertain negative cash flow is therefore often more critical from a decision-making perspective than a certain one.
The risk-adjusted discount rate method, however, implicitly treats this risk as a relief – and can thereby lead to systematically biased valuations.
Instead of changing the discount rate, the cash flow itself is adjusted:
Risk is accounted for on the cash flow side – not in the discount rate.
It remains economically consistent – regardless of the sign of the cash flow. Negative risks are not “discounted away,” but correctly reflected.
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