This text tries to examine the impact of risk estimation in the RADR on the estimates of project values using two methods which are the empirical survey literature and the textbook literature. The empirical survey literature focuses on RADR and textbook literature which focuses on estimation risk. (I)Estimation risk and biased present values estimates(a)Illustration of the nature of bias: this goes to explain that there will error and estimation problem when estimating the true discount rate because the decision maker does not know the RADR.
(b)Biases in present value estimates: this explains that the cash flows and RADR are subject to estimation risk which can cause the estimate of any project’s PV to be biased.(c)Illustration of the magnitude of the bias: Some limitations must be placed on the distribution of the estimate of the RADR to assess the extent of the bias. We are made to understand that the bias grows with the project life. (II)Correcting for the estimation risk induced bias: there are various approaches that can be used to correct estimation risk induced bias which are stated as follows(a)An ad hoc approach: this approach requires reducing the estimated present value.
Shareholder wealth can however increase using this approach if done correctly.(b)An Options-based Approach: this approach is an application of certainty equivalents. Any certainty equivalent approach yield unbiased estimates of project values.(c)Analytical expectation and numerically evaluated expectations: An unbiased estimate of a project can be done by dividing the estimated PV of each cash flow by a correction factor.
This is the ratio of expected value of the estimated PV to the true value. A general correction factor can be determined for any sampling distribution with an analytical expectation.(d)Unbiased estimation of PV:An analytical approximation to an unbiased estimator of the discount factor can be derived for any sampling distribution.This method and the analytical expectation and numerically evaluated expectations both eliminate PV bias although the analytical approach is more difficult to apply. This approach will be preffered by manager who are less sure of the properties of the sampling distribution of the RADR because it requires less knowledge of the sampling distribution.In conclusion neither the textbook literature nor the empirical survey liberation addresses the issue of capital budgeting with estimation risk in RADR.
In the process of ignoring estimation risk in the RADR, overvaluation of project cash flows occurs. This provides additional explanation to the observation that managers reduce estimates prior to making capital budgeting decisions. Several methods of reducing the bias arising from estimation risk in the RADR were talked about which include the fact that decision makers behave in a way consistent with assumptions that they wish to reduce bias.However the extent of estimation of risk caused by bias managers face in actual practice is not known yet, and because of this an important next step should be an empirical test to access the magnitude of the bias and differentiate among existing theoretical explanations for the biased PV estimates.
