V O LU M E 2 0 | N U M B E R 2 | s p ring 2 0 0 8

Journal of
APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Valuation and Corporate Portfolio Management

Corporate Portfolio Management Roundtable 8 Panelists: Robert Bruner, University of Virginia; Robert Pozen,
Presented by Ernst & Young MFS Investment Management; Anne Madden, Honeywell
International; Aileen Stockburger, Johnson & Johnson;
Forbes Alexander, Jabil Circuit; Steve Munger and Don Chew,
Morgan Stanley. Moderated by Jeff Greene, Ernst & Young

Liquidity, the Value of the Firm, and Corporate Finance 32 Yakov Amihud, New York University, and
Haim Mendelson, Stanford University

Real Asset Valuation: A Back-to-Basics Approach 46 David Laughton, University of Alberta; Raul Guerrero,
Asymmetric Strategy LLC; and Donald Lessard, MIT Sloan
School of Management

Expected Inflation and the Constant-Growth Valuation Model 66 Michael Bradley, Duke University, and
Gregg Jarrell, University of Rochester

Single vs. Multiple Discount Rates: How to Limit “Influence Costs” 79 John Martin, Baylor University, and Sheridan Titman,
in the Capital Allocation Process University of Texas at Austin

The Era of Cross-Border M&A: How Current Market Dynamics are 84 Marc Zenner, Matt Matthews, Jeff Marks, and
Changing the M&A Landscape Nishant Mago, J.P. Morgan Chase & Co.

Transfer Pricing for Corporate Treasury in the Multinational Enterprise 97 Stephen L. Curtis, Ernst & Young

The Equity Market Risk Premium and Valuation of Overseas Investments 113 Luc Soenen,Universidad Catolica del Peru, and
Robert Johnson, University of San Diego

Stock Option Expensing: The Role of Corporate Governance 122 Sanjay Deshmukh, Keith M. Howe, and
Carl Luft, DePaul University

Real Options Valuation: A Case Study of an E-commerce Company 129 Rocío Sáenz-Diez, Universidad Pontificia Comillas
de Madrid, Ricardo Gimeno, Banco de España, and
Carlos de Abajo, Morgan Stanley
Real Asset Valuation:
A Back-to-basics Approach
by David Laughton, University of Alberta, Raul Guerrero, Asymmetric
Strategy LLC, and Donald Lessard, MIT Sloan School of Management
O
B
ne of the most important responsibilities of
corporate managers is to evaluate and choose
among major investment projects. The role of
analysis in this decision-making is to help iden-
tify the alternatives that managers should consider and to
support high-quality conversations, using information from
throughout the organization, that lead to the best choices
possible. This is true whether decisions are made centrally or
by the business units. One requirement of asset valuation in
this context is that it judge competing decision alternatives on
a “level playing field.” A second requirement is that it support
an effective division of labor between the front-line manag-
ers who possess the most relevant technical and commercial
information about the business or project in question, and
the corporate center charged with providing the inputs for
economy-level variables and ensuring the consistency and
integrity of the entire process.
One reason why the prevailing standard for asset valuation,
discounted cash-flow (DCF) analysis, has persisted despite
widespread recognition of its limitations is that it is believed
to meet these two criteria at least as well as other alterna-
tives. With DCF, all proposals face the same corporate hurdle
rate, creating the perception of a level playing field. Project
or business unit-level considerations are “rolled up” into the
projected cash flows, while corporate-wide risk adjustment
and financing considerations are built into the discount rate,
thus achieving the desired division of labor. But DCF, at least
as commonly practiced, has two limitations that introduce a
number of biases and violate the two criteria.
First, most DCF analyses are based on a “static” view
in which future decisions are assumed to depend only on
information available now and not on additional informa-
tion that would be available when the decision is made. For
this reason, static DCF does not allow front-line managers
to model future flexibility explicitly and makes it difficult to
value—and indeed tends to undervalue—those investments
for which flexibility is an important source of value.
Second, most DCF implementations use a single discount
rate in the analysis of all decisions or, at best, establish different
discount rates for just a few large classes of decisions. This one-
size-fits-all approach to the valuation of risk may be adequate
for understanding the value of the “average” asset, but it fails to
reflect the variety of asset designs that can feature very different
46 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
types and levels of uncertainty. For example, the use of a single
discount rate, chosen with an average asset in mind, typically
undervalues proposals to spend in the near term to reduce
longer-term costs or increase longer-term revenues. Moreover,
it systematically misvalues investments with so-called “non-
linear” payoffs—not only investments with built-in flexibility
(which has been the focus of the real options literature) but,
as we discuss below, those presenting the challenges posed by
complex interaction of multiple uncertainties, certain types
of tax or other contractual obligations, and real asset design
features like constraints on production capacity.
To be sure, managers can and do attempt to improve DCF
valuation by adjusting discount rates to reflect differences in
risk among business units or types of decisions, or changes over
time in risk or other circumstances. But in the absence of clear
methods for making such adjustments, the process is likely to
be overly influenced by political considerations, undermining
the level-playing-field role of valuation. Many managers are
aware, at least at an intuitive level, of some of the biases of
DCF, and some managers attempt to circumvent them using
ad hoc approaches such as assigning high “strategic” value to
particular decisions. But such practices undermine the ability
of senior management to enforce common standards of analy-
sis across business units, asset classes, and types of decisions.
In this paper, we show that overcoming the limitations
of conventional “static, single-rate” DCF valuation requires
two separate types of tools: a disciplined process for adjusting
values for risk that goes beyond the single rate; and a method
of modeling future decisions that makes valuation “dynamic”
rather than static. We present an approach for adjusting values
for risk that rigorously applies the principles of time and risk
discounting to each potential cash flow rather than, as in the
case of DCF, to an aggregated measure of the cash flows. We
show that adjusting for risk on a “state-by-state” basis ensures
consistency with external markets and internal consistency in
the treatment of risk. We call this “market-based valuation,”
or “MBV,” for reasons made clear shortly.
To model future flexibility, we propose an approach based
on decision tree analysis (DTA). Some organizations already
routinely use a limited form of DTA to analyze a few select
types of flexibility. Our proposal is to broaden the application
of DTA significantly. To distinguish this from the relatively
narrow use of DTA in current practice, we call our proposal
complete decision tree analysis, or “CDTA.”
In sum, our approach provides two important techni-
cal improvements over DCF: consistency in accounting for
risk through MBV and capture of flexibility in decision-
making through CDTA. By improving their valuation
approaches in these two ways, companies can satisfy two
often competing organizational requirements. They can
enable unbiased, decision-oriented modeling of specific
commercial situations. At the same time, they can strengthen
senior management’s ability to articulate clearly, and consis-
tently, the shared rules of engagement for decision evaluation
throughout the organization.
In discussing potential bias in valuation approaches, it is
useful to start by setting up a benchmark. In a corporation
funded with publicly traded securities, or one mandated to act
as if it were, this benchmark is the financial market value of the
assets involved. DCF is intended to estimate such values when
they are not directly observable. Many corporate analysts are
aware of at least some of the ways in which static, single-rate
DCF fails to estimate financial market value properly. Never-
theless, many of these same people also assume that whether
the DCF valuation result is “right” in an absolute sense or
not, the corporate-wide use of a single discount rate has the
virtue of penalizing all decision alternatives equally, and so
preserving the relative ranking of the alternatives. But in fact,
this usually will not be the case. Different valuation tools
will return different relative rankings of managerial choices,
not just different absolute value estimates.1 Toward the end
of the paper, we show an example of this in a case study of a
carbon capture and storage (CCS) opportunity. This oppor-
tunity can be managed in different ways, each requiring a
total investment of about $100M. In a version of the case, if
managers execute the management policy suggested by DCF
methods, they destroy about $13M in value by turning an
asset worth more than $8M into one with a negative value
of close to $5M.
The first part of our challenge, then, is to identify the
source of the biases in current methods and propose ways of
eliminating them. The second part is to demonstrate how our
suggested technical changes can help management improve the
process by which a company uses valuation estimates and other
information to make decisions. The crux of our argument is
straightforward: a corporate-wide discount rate policy is simply
too blunt an instrument to control the huge variety of corpo-
rate initiatives that must be evaluated. In fact, as we show later,
a single discount rate cannot even be relied on when evaluat-
ing different alternatives for developing a single asset if the
alternatives differ substantially in terms of variables like capital
intensity, operating leverage, or expected life. And even with
1 Note that selling the asset, or even the entire company, is frequently an alterna-
tive, so if nothing else, an incorrect valuation changes the order of this monetization
alternative.
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
a varying discount rate, static DCF technology itself is too
limited and inflexible to reflect the economics of most corpo-
rate decisions, particularly those that are strategic in nature.
In the corporate valuation process that we propose, local
teams focus on the characteristics of the project that are
unique, while the corporate center specifies the rules of the
game and controls the modeling of pervasive, economy-level
risks. The proposed division of labor is as follows:
(1) Asset teams or business unit managers develop the set
of decision alternatives to be formally analyzed and “own” the
modeling of asset-level uncertainties, such as the amount of
oil in a field or the likelihood of developing a new technol-
ogy. Local teams have a clear comparative advantage over the
corporate center in these aspects of the valuation process. A
suitable peer review can serve as a check on this activity.
(2) Central finance staff specifies a standardized treatment
of economy-level risks, such as commodity price risk. This
function is analogous to a central group’s responsibility for, say,
determining and disseminating a corporate-wide hurdle rate.
But note that, in our approach, the group does not focus on
modeling the risk of typical company projects, but rather on
the risk associated with fundamental economic drivers such
as oil prices or the growth in GDP. A specialized central unit
usually has a comparative advantage in understanding how to
model such risks, which must be modeled uniformly across the
corporation to ensure consistency in the valuation process.
(3) Senior management centrally specifies a valuation
approach that is general enough to handle most problems
involving different types of decisions and the interaction of
different types of uncertainty,2 thereby minimizing the need
for ad hoc “excursions” outside of the framework.
In this paper, we do not focus on how an organization
might manage the process of implementing the changes we
are proposing, but we do want to make one comment in that
vein here. Many firms that use DCF have something like this
division of labor already. For those firms, the approach we
advocate is designed to maximize the gain in analytical under-
standing while minimizing the amount and cost of change.
For those that are not organized in this way, our approach
makes it easier to achieve this alignment if desired.
We recognize that it is not typical to address asset pricing
techniques and organizational concerns within the same paper.
But as we will demonstrate, the technical and organizational
sides are closely linked. Our aim in the pages that follow is
to present a broad enough picture of the practical advantages
and applicability of our methods suitable for managers, while
at the same time providing enough detail to enable valuation
specialists to begin to apply our recommendations to their
internal processes.
2. From a computational point of view, this is similar to what Borison (2005a) calls
“the integrated approach,” but, as we show in the Appendix, the basis we provide for it is
very different, and in ways that have important practical implications for its use.
47
The Four Linked Aspects of Asset Valuation
At the level of fundamental theory, we are proposing noth-
ing that goes beyond the foundations laid by Fischer Black,
Myron Scholes, and Robert Merton in their pioneering work
on option pricing in the early 1970s.3 The academic exposi-
tion of asset pricing requires analysts, first of all, to account
for differences in risk among assets. The theory also instructs
analysts to account for changes in the risk of a given asset over
time, and to reflect the value of “contingency” in decision-
making—that is, the ability of management to respond to
changes in key variables over time.4 Our suggestions for imple-
menting these foundational concepts are an elaboration of
the approach to real asset valuation that was first clarified by
Michael Brennan and Eduardo Schwartz over 20 years ago,5
and that has been further developed and refined by many
since then. But even with such a long gestation period, the
ongoing debate in the real options literature suggests that the
logic behind this approach is not well understood and needs
to be revisited in a systematic way.6
With this goal in mind, in this section we break asset
evaluation down into the construction and use of four linked
models and discuss the characteristics of each, note potential
problems with current approaches, and present our proposed
improvements. The four models are these:
(1) a decision model, which contains an explicit statement
of the alternatives the corporation is considering;
(2) a cash-flow model, which shows the relationships
required to determine the cash flows;
(3) an uncertainty model, which provides the probability
distribution of the uncertain inputs to the cash-flow model;
and
(4) a valuation model, which shows how value is deter-
mined from the streams of possible cash flows created by the
other models.
Expanding the decision model. It may seem unneces-
sary to ask analysts to state explicitly what is actually being
decided at the start of an evaluation, but in fact the way a team
frames the problem at hand—that is, the act of articulating
its decision model—can have a significant effect on the actions
that are eventually taken. Our main concern is that companies
often do not model “contingency”—again, the possibility of
management response to changes in key variables—during the
decision-modeling stage, even when they are aware of important
sources of flexibility in the future management of the asset.
For example, a car company may frame its decision model
for an opportunity it is considering as follows: “When in the
next five years, if at all, should we launch a battery-powered
model using our patented but not completely developed
battery technology?” Putting the question this way requires a
3. Black and Scholes (1973) and Merton (1974).
4. Even in introductory books such as Brealey, Myers and Allen (2006), contingent
decisions are discussed and real options is proposed as a modeling tool.
48 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
choice among alternatives such as “launch in 2009,” “launch
in 2010,” and so forth, or “launch never.” This rules out the
possibility that management will wait for still more informa-
tion about the likely success of the project before making
a decision. The actions taken today, based on that decision
model, are effectively determined within the context of a
future launch that is pre-committed.
For most situations, however, pre-commitment is a poor
model of how a company actually intends to manage its
assets. For the auto company, the asset is the opportunity to
launch a new green model. The decision rule the car company
actually intends to follow with respect to the launch is probably
something along the lines of: IF gasoline prices remain high,
car buyers remain interested in green products, our produc-
tion costs are low enough to make the car marketable, and the
overall demand for cars is high enough, and IF we have done the
work needed to be able to launch, THEN we will launch; ELSE
we will continue to monitor developments. That rule readily
takes the form of a decision-tree structure. There are multiple
sequential decisions—for example, how different pre-launch
choices might constrain the possible times at which we can
launch, or how such choices could influence the demand or
cost conditions at any time we might wish to launch. There are
also many sources of uncertainty, including external, economy-
level uncertainties like overall demand for cars and the price
of gasoline, as well as internal, asset-level uncertainties, such
as how well our particular patented battery technology will
work and when it will be available given different patterns of
research effort. You have to put this type of structure into your
evaluation process if you wish to consider contingent strategies
explicitly and thoroughly. If you have not put it in, you are
effectively modeling pre-committed decisions.
We believe that asset realities, such as the contingencies
we have just discussed, should inform the decision model,
which in turn should determine the cash flow and uncertainty
models. In our own experience with companies, a different
causal chain tends to prevail—one in which the existing uncer-
tainty and valuation models effectively determine the way
decisions get framed. If “deterministic” base-case cash flows
are used in the DCF model, there tends to be little model-
ing of uncertainty, and decision modeling remains outside
of the process. On the other hand, if probability-weighted
expected cash flows are used, as they should be, distribu-
tions of outcomes are usually simulated, but often without
adequate modeling of the decisions involved. We cannot fault
analysts or asset champions for choosing to spend their time
on the static DCF analyses that are understood and expected
by senior management. But, as we have already suggested,
there is a major downside to this kind of decision-making: a
5. Brennan and Schwartz (1985).
6. Some of these debates have occurred in this journal. See, for example, the fol-
lowing articles on the “Georgetown Debate”: Borison (2005a), Copeland and Antikarov
(2005) and Borison (2005b).
systematic failure to make the most of the wealth of informa-
tion, both inside and outside of the organization, about the
best way of increasing its long-run value. To help address this
problem, management must develop and support an analytical
technology that is capable of handling contingent as well as
pre-committed decisions.
Those of our readers who are familiar with the real options
(RO) literature will filter our discussion of the decision model
through that lens. The essence of RO is that flexibility has
value, and we certainly agree with that concept. We do have
concerns, however, about how the concept is implemented
in specific real options valuation models, and we urge readers
to apply the same criteria when judging RO models as when
judging DCF models. Most important, does the technol-
ogy encourage and enable analysts to make the most of the
information that the organization has about a particular asset?
Forcing an asset to match a financial-market “look alike,”
which is the essence of many RO approaches7, will only rarely
capture the economics of actual decisions involving real assets.
And requiring the flexibility to be modeled as an “add on” to
an asset without any flexibility—which is the essence of many
other approaches8—is also very restrictive.
The cash-flow model. With a decision model in place, the
analyst next develops a cash-flow model. This is the arena
where different types of inputs are gathered together to deter-
mine the stream of cash flows that will occur in any possible
future scenario. The cash-flow model takes the form of a set
of relationships such as:
cash flowt = revenuet - costt - taxt.
In this case, there would also be sub-models for revenue, costs,
and taxes. For example, in the battery car example, the revenue
could be modeled as the price of the car multiplied by the quan-
tity sold. There would then be a sales model that relates the
quantity sold to the price set and to drivers of demand like the
overall consumption or GDP index and the price of gasoline.
The cash-flow model has two types of inputs. First there
are the variables, such as the time of launch in our battery car
example, that are used to specify which decision alternative is
being considered. These control variables are the link between
the decision model and the cash-flow model. Second are the
uncertain inputs, such as the GDP index and the price of
gasoline in our example, that drive the overall uncertainty in
the cash flows. These inputs are important enough that they
have their own model: the uncertainty model.
The uncertainty model. In the example we are consider-
ing, the uncertainty model would include a joint probability
7. An example is much of the RealOptions ToolKit described in Mun (2003).
8. The most widely known example is Copeland and Antikarov (2002).
9. Note that, in so-called “deterministic” DCF analyses, the analyst does not work
with entire probability distributions, but rather a single forecast or a small number of
forecasts. In our terminology, these single point estimates of gasoline price, GDP, etc. are
still an uncertainty model, but a limited one.
10. The uncertainty about the success of the technology will not be correlated with
uncertainty in the overall economy if, on the one hand, it is measured by physical, sci-
entific criteria—not influenced by the economy and if, on the other hand, our project is
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
distribution of the GDP level and gasoline prices.9 On the cost
side there might be a technical success variable that specifies
the uncertainty that the remaining R&D being done on the
battery technology will make the battery more or less expen-
sive to make.
There are three points to be made about the uncertainty
model. First, it must be quantitative, even if this is difficult to
do. In the case presented near the end of this paper, we model
the future price of CO2 emissions based on limited informa-
tion, but what is the alternative? Second, if the uncertainty
model is to support the analysis of future decisions made with
information available only in the future, we must have some
idea of how that information will arrive over time (e.g. will
the company learn about a variable a little at a time or all at
once.) Therefore it will need to include both the probability
distribution of the uncertain inputs into the cash model and
any variable that describes that information flow. Third, it is
important from a valuation point of view, as well as from an
organizational one, to distinguish between those variables
that are correlated with uncertainty in the overall economy,
such as the price of gasoline or the GDP index, and those that
are uncorrelated with the economy, as the technical success
variable may be.10
The valuation model. The role of the fourth and final model,
the valuation model, is to account for the two characteristics of
cash flows that are of primary concern to corporate investors:
timing and risk. Most methods of asset valuation treat time
by discounting with a risk-free discount rate. Where methods
tend to differ is in their treatment of risk. How this is done,
and in particular at what level of aggregation, is central to the
ability of a valuation approach to account for risk consistently.
The current best practice in this regard is known as “state-
pricing.”11 As discussed in more detail below, state pricing is
a more general version of the single risk-adjusted discount rate
approach taught in introductory MBA courses—and it can be
traced back, in the form we use it, to the Black-Scholes and
Merton approach to asset valuation and its descendants.
In the next few sections, we present some of the potential
problems with single-rate discounting and how they can be
managed, at least in relatively simple situations, by a shift to
an MBV method called “forward pricing.” We will also see,
however, that forward pricing can take us only so far, and that
it breaks down in cases involving non-linear cash flows, which
arise with managerial flexibility and for other reasons. Once
our description of forward pricing is done, we will have the
vocabulary to present formal definitions of MBV and CDTA.
small enough not to influence the economy by itself. It will satisfy this second condition
if, for example, it is but one of many such projects, at least one of which is bound to
succeed.
11. MBV and state pricing are closely related but not synonymous. MBV refers to a
general approach for carrying out valuations by using financial market data as much as
possible in a consistent manner. State pricing is a specific technique to value cash-flows
by considering them on a state-by-state basis. We shall see that the MBV approach
can be implemented by using state pricing or, in certain circumstances, by using a less
general technique called “forward pricing.”
49
We then return to the more complex situations characterized
by non-linear cash flows, where we will find that we must turn
to the state pricing implementation of MBV.
DCF and MBV for Simple Cash-flow Models
The formula you are probably most familiar with for DCF
valuation looks something like:
V = Σt expected cash flowt / (1 + k) t
where V stands for value, Σt means “sum over times labeled by
t” and k is the DCF discount rate. We refer to 1 / (1+k)t as the
discount factor for the time t. One point before we continue,
the continuously compounded version of the formula for the
discount factor is e-k*t, where k is the continuously compounded
discount rate. This is the formula most commonly used in
financial markets and we shall use continuous compounding
henceforth in this paper.
We will find it useful to express the discount factor as
a product of two factors—one to compensate for the time
value of money and the other to compensate for risk—so
that: Discount Factor = Risk Discount Factor * Time Discount
Factor. The time discount factor is generated by the risk-free
rate, and it accounts for the time value of riskless money. The
risk discount factor accounts for risk only and the rate that
produces it is frequently called the risk premium.
Let’s explore a very simple cash flow model: Cash flow t =
Revenue t - Costs t. When we apply a discount factor to this
cash flow, we are implicitly applying the same factor to both
the revenues and the costs. Almost always, the uncertainty of
each component of cash flow will be different, with revenues
typically more uncertain than costs. A single discount factor
may still give a good estimate of value, but only if it is a kind
of weighted average of the “true” discount factors for the cash
flow components. The problem, however, is that the correct
average discount factor will change whenever the “true”
discount factors for revenues or costs change, or the weights
of revenues and costs in the overall cash flow change. For
example, in a growing company, the ratio of revenues to costs
typically changes over time. To remain consistent with such a
change in the asset structure, the single discount factor would
have to change, even if the riskiness of revenues and costs
themselves remained constant across projects and time.12
What happens if we abandon the single corporate rate
version of DCF and try to adjust the discount rate to the
situation we face? The technical problem is that, in most
situations, analysts are likely to have less intuition about what
the overall discount rate should be than about the discount
rates for the components of the cash flow.13 Consider, for
example, the case where an analyst models the revenues of
12. These points are well recognized, but often swept under the rug. For an early
exposition see Robichek and Myers (1966), Myers (1974) made this type of argument in
introducing the APV approach and Lessard (1979) extended it in international applica-
tions involving multiple uncertainties, tax regimes, etc.
13. This technical problem is on top of the organizational problems associated with
this procedure.
50 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
the potential battery car business unit as a linear function of
the GDP index and the price of gasoline, while the costs are
assumed to be known with certainty. An example would be
the following model for the cash flow in 2015 (assuming we
launch before then):
100M gallons * price of gasoline + $2M * US GDP index
- $150M, where the GDP index for this year is 100.
In this case, the appropriate discount rate for the risk-free
component of the cash flow—the negative $150M—is simply
the risk-free rate.
As for the gasoline price component, recall that the
forward price of a commodity is the given known amount of
cash that one can contract for today to buy a commodity at
a defined future time. Therefore, the forward price is simply
the expected commodity price discounted for risk but not
time. The component of the cash flow related to the gasoline
price is equivalent to a claim to 100M gallons of gasoline in
2015. If we have the forward price for gasoline, we can value
this by discounting the quantity (100M gallons * gasoline
forward price) for time only.
There are forward prices for gasoline that run to maturi-
ties of three years. In cases where there are reliable market
forward prices for the relevant maturities, they should be used.
In their absence, forward prices can generally be estimated
using a forward market model based on both past and current
forward prices.14
What about the component of overall cash flow that
is proportional to the GDP index? One can generalize the
concept of forward price to refer to any cash-flow amount,
not just a commodity price. Indeed, there are the equivalent
of forward contracts on stock market indices that are traded
in futures markets in volumes much larger than the trading
in the stock markets themselves. Thus one could imagine a
forward price for the GDP index. If we can estimate it, the
value of the claim to the overall cash flow being considered
would be:
(100M gallons * gasoline forward price + $2M * GDP
index forward price - $150M) * time discount factor.
The forward price of the GDP index is just the amount of
the cash flow in question discounted for risk but not time. A
number of studies have shown that the discount for risk in a
broad-based economic index like GDP or the S&P 500 equals,
in annual terms, about half the annualized standard deviation
of the forecast return of that index.15 Using this result, the risk
discount factor built into the forward price for the GDP index
could be roughly estimated initially as follows:
exp (-0.5*cumulative annualized uncertainty in the GDP
Index forecast)
14. Such models are in common use in financial markets. See Geman (2005) for a
recent monograph on this topic.
15. Brealey, Myers and Allen (2006) refer to this in their discussion of the capital
asset pricing model (CAPM). An example is Ibbotson and Sinquefield (1976).
The organization could also choose to put resources into a
more accurate determination using a more detailed model of
this risk discounting.
Non-linearity and Valuation
The corporation that is willing to move away from a single
discount rate for all cash flows and cash-flow components
can get much more insight into the effects of risk on value.
We refer to this “multiple-rate” DCF technology broadly
as forward pricing because of the central role played in it by
forward prices.16
Unfortunately, forward pricing works only when the
cash flow can be divided into additive components, one for
each driver with a forward price observed or otherwise deter-
mined—or, in other words, when the cash-flow model is linear
in those drivers. Managerial flexibility and other sources of
“non-linearity” violate this condition.
Flexibility introduces non-linearity because different
decisions made in the future will change the relationship
between inputs and cash flows in different ways. For example,
suppose that the car company we have been discussing faces
a choice at a single time in the future to launch the battery-
powered product or not, and we have estimated the value at
launch as follows:
500M gallons * gasoline price + $10M * GDP index
-$3000M
If we want to model the realistic assumption that the
company will launch only if the value is positive, this contin-
gency translates to a value at startup of:
max(500M gallons * gasoline price + $10M * GDP index -
$3000M,0)
This is not a linear function of the gasoline price and GDP
index.17
Non-linearity can arise for other reasons as well. When
there are capacity constraints, for example, production and
thus sales cannot rise beyond a certain level. The car company
can always build another factory; but while it is doing so, the
cash flows will not move in a linear fashion with the drivers.
Contractual terms are another common source of non-linear-
ity. The car company may have a previous owner that requires
an additional payment (a clawback or earnout) if profitability
exceeds a certain level. Tax regimes are another potential source
of non-linearity through, for example, tax loss carryforwards
or income limits on the use of tax credits.
16. This approach is also sometimes called certainty equivalent valuation. Certainty
equivalent is just a more general term for forward price.
17. For example, if the GDP index is 100 and the gasoline price is anything less than
$4 per gallon, the launch does not take place and the value turns out to be zero. But
at a GDP index level of 100 and above $4 per gallon, the start-up value of the project
increases by $50M for each 10¢ per gallon increase in price. A different relationship
between inputs and value over different ranges for inputs is the defining characteristic
of non-linearity.
18. With linear cash flow models, we can get away with knowing only expectations of
the inputs because of the rule in statistics that “the mean of the sum is the sum of the
means”. This rule cannot be applied if the cash-flow is not a sum of the uncertain input
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
In the DCF analysis of the linear cash flow model we
presented above, the expected cash flows are determined solely
in terms of the expected forecasts of the cash flow drivers. But
this approach breaks down in the face of non-linearity because
we then need to know the entire distribution of the driver,
not just its expectation, to calculate the expected cash flow.18
This requires a shift in mindset—one that can be facilitated
by simulating the value drivers, for example, and letting the
spreadsheet or program calculate the expected cash flow.
Forward pricing breaks down for essentially the same
reason. From a computational point of view, the correct
expected cash flow can be calculated using simulation, as we
have just suggested. But this approach leaves open the question
of how to treat the effect of risk on value when the dependence
of the cash flows on their underlying determinants is compli-
cated by non-linearity. To treat risk properly, we turn to state
pricing, which we shall introduce shortly.
MBV-CDTA
Our walk-through of the four models in asset evaluation (as
yet incomplete for the valuation model) has already suggested
what we would like to improve. First, we would like to be able
to model decisions that present themselves as complex deci-
sion trees. Second, we would like a method for treating risk
more consistently. These two dimensions are a very general
way to distinguish between valuation approaches.
Our method improves on current practice along both
dimensions. It consists of two approaches—Complete
Decision Tree analysis (CDTA) and Market-based Valua-
tion (MBV)— that can be used independently but are most
powerful when combined. Along the risk valuation dimen-
sion, MBV uses techniques, and as much as possible data,
from financial markets to ensure an internally and exter-
nally consistent treatment of risk. The focus on financial
market data is why we call it “market-based” valuation.19
It accounts for risk at its sources, and maintains the entire
distribution of cash flows until the final step of the valua-
tion.20 Along the decision modeling dimension, CDTA
uses decision trees to model decisions throughout the asset
life cycle made in response to the resolution of all types of
dynamic uncertainty.
In the next section (and the Appendix) we provide a more
detailed account of how MBV works in general. Before we do,
however, a few more words about what we mean by “complete”
variables, i.e. is not linear.
19. The term “MBV” was initiated in 2003 by the participants at a Society of Pe-
troleum Engineers workshop on asset valuation in the upstream petroleum industry to
replace an older term—“modern asset pricing” (MAP)—since this notion of “modern”
was then over 30 years old.
20. We explain each of these choices in the course of the paper, but here is the quick
explanation for the reader already familiar with some of this material. We adjust for
market-priced risk in fundamental drivers using state pricing, model the interaction of
the risk-adjusted variables with other parameters, accounting for non-linear payoffs, and
then discount the risk-adjusted (or as some others refer to it the “risk-neutral”) cash-flow
expectations for time.
51
decision tree analysis. Most companies that use DTA do so
only to examine information-gathering decisions made early
in the asset life cycle, such as R&D or, in the case of mining
and oil and gas, exploration and appraisal. When they do so,
moreover, they usually look at the impact of changes in only
the asset-level variables while ignoring the effect of uncertain
changes over time in the external commercial environment.
CDTA is “complete” both in the sense of modeling flexibility
throughout the entire asset life cycle (for example, by allow-
ing the eventual closing costs of a mine to influence decisions
today) and modeling within a single framework the impact on
decision-making of changing uncertainty in economy-level as
well as asset-level variables.21
State Pricing and MBV
State pricing is the technical engine of MBV for general cash-
flow models and the basis of the current standard for asset
valuation in financial markets. A “state” is a condition at a
given time of the variables in the uncertainty model.22 For
example, one state in an uncertainty model for the battery car
opportunity for the year 2015 might be specified by the gaso-
line price at $3.15 per gallon, the GDP index at 101.5, and the
technical success of the engineering design of an engine that
delivers 100 horsepower. Another state might be gas at $2.80
per gallon, the GDP index at 102.1, and the technical failure
of the engineering design. In this example, the gasoline price,
GDP, and engineering outcome are all “state variables.”23
To gain an intuitive understanding of state pricing,
consider a situation where there is only one state variable, the
GDP index for next year.24 If you had the opportunity to buy
a bond (which we call a high-GDP bond) that paid $10,000
a year from now if the GDP index were between its 50th and
100th percentile (say, 103–106), and an opportunity to buy
a second bond (the low-GDP bond) that paid $10,000 a year
from now if the GDP index were between its 0th and its 50th
percentile (say 96 to 103), what price would you pay for each?
In particular, would these prices be the same?
If the economy is doing well and growing at perhaps
significantly greater than 3% next year, your job and other
aspects of your finances are more likely to be going well, and
the extra $10,000 would be nice to have: perhaps it represents
an upgrade on which new car you buy. If the economy is
doing poorly, your overall finances are likely to be going less
well, and the extra $10,000 may mean the difference between
21. Some readers will be aware that it is difficult to model the appropriate discount
rate to use within a decision tree, if DCF methods are used to value payoffs on the tree
and if an attempt is made to find a discount rate appropriate for the situation as opposed
to using a corporate hurdle rate. We can sidestep this problem by using MBV to adjust
for risk first, then discounting these risk-adjusted payoffs with the risk-free rate within
the decision tree.
22. Recall that these are the uncertain inputs into the cash flow model and any
other variables needed to determine the dynamic behavior of information about those
variables.
23. When we introduce state pricing, some students and clients express concern
about the large, possibly limitless, number of states. The intuition is right, but this is
the reality of the potential futures for a typical real asset, and, as we shall show in the
52 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
staying in your current apartment or moving to a cheaper
neighborhood. Most people would agree the low GDP bond
is worth more to them. This is simply a manifestation of risk
aversion: We prefer to smooth our income so that the lows are
not too low; and to achieve this goal, we are willing to give up
the possibility that the highs are very high.
We could repeat this exercise for increasingly finer equal
probability partitions of the state variable, until we had a
different bond for each state, which we could call a state-
bond. Each bond would have a different price, but since all
the bonds have the same expected payoff and mature at the
same time, this must mean that a different adjustment for risk
would apply to each state. This is the result that provides the
general principle underlying our pricing algorithm—namely,
that different states may have different risk adjustments.
We can use this result to understand better how DCF works
and where it might have problems. With DCF, we first deter-
mine an average measure of the cash flow at each time—that
is, we estimate the expected cash flow. This average is actually
(at least supposed to be) a probability —weighted sum over
the cash flow that occurs in each state. Then we discount the
expected cash flow using the risk discount factor (RDF) and the
time discount factor (TDF). We can “open up” the expected
cash flow calculation to see what is actually going on:
E (CF) = sum over all states ‘s’ (cash flow in each state *
probability of each state occurring)
The formula for value is:
V = E(CF)*RDF*TDF
In this equation, the RDF and the TDF are constants, so we
can write:
V = sum over all states ‘s’ (cash flow in ‘s’ *probability of
‘s’ * RDF * TDF)
DCF accounts for risk with the same risk discount factor for
each state at any given time.
The corresponding equation for state pricing in MBV is
very similar, except we use a different risk discount factor for
each state:
V = sum over all states ‘s’ (cash flow in ‘s’*probability of
‘s’ * RDFs * TDF)
This makes clear the difference between DCF and state pric-
ing. DCF uses an average risk discount factor and applies it to
all states; state pricing uses individual risk factors.25
The linear/non-linear distinction that drives all of this can
seem quite mathematical, but we can offer a good heuristic.
example below, modern desk-top computer power can be harnessed to manage this large
number of states to our advantage. A large number of states can actually be used to
increase our understanding of a situation, as we shall see in the Gascom case.
24. This is more or less implicit assumption when you use the CAPM and a beta
calculated on the S&P 500 Index to derive a discount rate.
25. These risk discount factors are also called “risk adjustments” in the literature. The
risk adjustments multiplied by the probabilities are called “risk-adjusted probabilities” or
“risk-neutral probabilities”. The risk-adjusted probabilities multiplied by the relevant time
discount factor are called “state prices” The state prices are the fundamental economic
concepts, which is why the whole technique is called “state pricing” We discuss all these
terms further in the appendix.
If you naturally think about a situation in terms of overall
averages, the cash flow model in your head is likely to be
linear. If instead you think of the situation in separate pieces
(separate states) your cash flow model is probably non-linear,
and you may need state-pricing. For example, almost no one
speaks of the overall average performance of start-up firms.
We speak of the average performance of firms that last for
more than three years, and put those that fail early on in a
separate category. This is a non-linear idea: we have a piece
of the data, firms that collapse early, that gets treated one way
(perhaps even ignored), and another piece of the data, firms
that survive three years, that gets treated a different way. We
also don’t naturally think of the overall average revenues of new
projects such as the battery-powered car.26 We speak and think
in terms of a 30% chance that the car will not be launched at
all, and a 70% of achieving $10M a year revenue, conditional
on launch. Do you see how you are segregating your thinking
into a launch and a non-launch state?
State-by-state discount factors are determined collectively
using information we observe directly in financial markets,
such as forward prices. or they can be calculated from finan-
cial market structures and data. They are conceptually the
same as the risk discount factors we considered for the state
bonds above. This allows our risk discounting to reflect both
the structure of the underlying uncertainty that actually exists
in the uncertainty model for each situation we analyze and
the risk premia the financial markets assign to that uncer-
tainty.27
Although we show how this works out in the case study
that follows, we have two comments for you to keep in
mind:
First, all cash flows, whether linear or otherwise, can be
properly priced using this state-by-state approach. Second, if
we can observe or otherwise determine the forward price of
each of the state variables that define the uncertainty model,
we are a long way toward being able to determine what we
need to do our state pricing valuations. We provide more
detail on this final point in the Appendix.
Gascom Case Study28
We now provide an example showing the application of
MBV-CDTA to a realistic commercial situation with several
sequential decisions of different types that must be made in
response to changes in both economy-wide and asset-level
uncertainties.
Let us go back to late 2004.29 Gascom has made the
26. Of course, people can and do calculate overall averages for analysis, but our point
is that you should do so with caution if you tend to describe the situation in a “on one
hand this, but on the other hand that” basis
27. Note that forward pricing does just this in cases of linear cash flows.
28. The full Gascom example is available in Laughton (2008).
29. The first version of this case was presented in 2002 (Laughton et al 2002). The
version presented here uses economy-level uncertainty and valuation models that were
updated in late 2004. All monetary amounts are in 2005 US$. The asset-level uncer-
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
decision to develop an already well-defined offshore natural
gas field, but has to make another decision. Production from
this field would produce CO2 as a by-product, and any CO2
emissions to the atmosphere would be subjected to penalty.
One alternative for managing the emissions is to build a
carbon capture and storage (CCS) facility that will compress
the CO2, pipe it to an otherwise useless underground reservoir,
and inject it there. The alternative to building a CCS facility is
to emit the CO2 to the atmosphere and pay whatever charges
are then in force.30
The cost of the facility is expected to vary little and is
modeled as known with certainty. If the CCS facility is built,
the major operating cost will be the natural gas from the field
that is used as the energy source for the compression, trans-
port, and injection of the CO2. There is some uncertainty
about the amount of energy that will be needed for injec-
tion. This uncertainty will be resolved once injection begins,
but can be resolved earlier by a $5M well test, which would
also allow Gascom to tailor the design of the injection sites
and save 10% of the total gas needed for the CCS facility.
There are also two possible injection schemes—“basic” and
“enhanced”—that involve a tradeoff between injection drill-
ing costs ($5M more for enhanced) and the amount of gas
required for injection (10% less for enhanced, in addition to
the 10% saving if the well test is done).
We carry out a separate analysis for each of two possible
regulatory regimes for CO2 emissions. Under “cap and trade”
regulation, the price of CO2 emissions will be set by a market
for permits and is uncertain. With carbon excise tax regulation,
every tonne of CO2 emitted will incur a charge that is equal
to the current expected price for that year under the cap and
trade system. Since the quantity of CO2 emitted is modeled
as known and the cost per tonne is fixed, the costs of emitting
the CO2 under a carbon tax are known with certainty.31
Gascom has an immediate decision to make. It can build
space into its production platform now, at a cost of $10M,
for the compression aspects of its CCS facility. If this is done,
the cost of the whole CCS facility in the future will be $90M.
Otherwise, it can do nothing now; but if Gascom decides to
build the CCS facility later, it will have to retrofit the produc-
tion platform at an extra cost of $30M.
Setting up the Four Models. With this background infor-
mation, we can construct the decision model and the cash-flow
model for this opportunity. We show one part of each of these
models to illustrate what is involved.
The decision model consists of a series of statements like
tainty model, decision model and cash-flow model have been expanded for this paper.
30. Note that, for Gascom, the “revenues” from building the CCS facility are the
avoided emissions charges.
31. If a carbon tax were the regulatory instrument, in reality there would likely be
some uncertainty about its level. For simplicity, we have presumed that the government
can commit to it with certainty. The thrust of our results will go through so long as the
tax is more certain than the price would be under cap and trade.
53
Figure 1 CO2 Price Model
CO2 Price Model
70
60
50
Price ($/tonne )
40
30
20
10
0
2005 2015 2025
Time (years)
the following: “in 2006 and later, if nothing has been done
other than the possible pre-investment in 2005, Gascom can
choose to do nothing, to conduct the well test, or to build the
basic or the enhanced CCS facility.”
The cash-flow model consists of equations like the follow-
ing for the net cash flow at time t, assuming the CCS facility
has been built and is operating:
1M tonne * CO2 _pricet – $1M - basic_no_test_gas_
amount*(1-0.1*(well_test + enhanced)) * gas_pricet
if t>startup_time, operatingt=1
In this relationship, the economy-level uncertain inputs are
the CO2 and gas prices at the time of the cash flow. The asset-
level uncertain input is the amount of gas needed if no test is
done and the basic injection scheme is used: “basic_no_test_
gas_amount.” The other variables—“well_test,” “enhanced,”
“startup_time,” and “operatingt”—are all so-called “control
variables” that are used to define the decisions that affect the
cash flow. More specifically, “well_test,” “enhanced,” and
“operatingt” are yes/no switches where the “yes” choice for
32. In this version of the analysis, we used a first “rough-cut” model of gas prices. It
was not based on any econometric analysis of past gas forward prices. In a corporation
with a fully operational MBV system, the econometrics would be done.
33. In this case the model of the MIT Joint Program on the Science and Policy of Glob-
al Change was used. Details may be found at http://web.mit.edu/globalchange/www/
34. The numbers used for this and the gas price model were intended to give the best
assessment possible of the true probability distribution. Frequently in DCF “valuations”
done now, “conservative” assumptions about the uncertainty variables are used to gener-
ate information about what “value” could look like if things go bad. This is stress testing,
not valuation. Another common practice is to generate distributions of DCF “values”, one
for each possible realization of the future, and statistics of this distribution are fed into the
decision-making process. This may be useful simulation, but it is also not value estima-
54 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
median
expect
forward price
p10
p90
2035 2045 2055
doing the well test, building the enhanced injection scheme
or operating the CCS facility at time t, respectively, is 1 and
the “no” choice is 0.
We next turn to the uncertainty model. Gas and CO2
prices, as noted, are economy-level uncertain variables. While
there is a lot of data about the past and current behavior of the
gas market that can be used to inform the gas price model,32
there is very little data about CO2 price behavior. Expert
opinion, informed by the use of a large-scale integrated assess-
ment tool,33 about the supply of CO2 to the atmosphere, the
political demand for emissions reductions, and the marginal
cost of meeting those reductions, was sought and incorporated
into the CO2 model.34
Figure 1 shows the expected CO2 prices used in the analy-
sis,35 as well as the median prices and the 80% confidence
interval around the medians. There are long-term equilib-
rium forces in the CO2 markets that tend to bring the prices
down when they get too high and drive them up when they
get too low. As a result, the amount of uncertainty about the
tion. Value is a price and, as such, is a number not a distribution. Our contention is that
in addition to this and other types of simulation, decision-making that should be based on
value maximization should have access to the best unbiased value estimates possible.
35. These are obtained from a dynamic probability model. For the reader interested in
the details, it is a correlated two-factor (one for gas and one for CO2) geometric diffusion
model in the expected price forecasts with volatility that declines exponentially with the
term of the forecast and that is time-dependent in the short-term. There are detailed eco-
nomic, political and physical stories behind the uncertainty and valuation models (see
Laughton 2008). These details are not important for the purposes of this paper, but it is
important that they exist and could provoke necessary discussions within a corporation
about their validity and limitations.
prices grows at a decreasing rate the farther out we look into
the future. Thus, the per-period uncertainty about long-term
prices is less than the per-period uncertainty about short-term
prices. Natural gas prices exhibit similar long-term equilibrium
behavior. We shall return to this point when we get to the
valuation model. Uncertainty about the two prices is positively
correlated over the time horizon we are considering.
The gas amount is an asset-level variable whose uncer-
tainty is resolved solely through managerial choice: either well
test or startup. It is not correlated with the economy-level
inputs of the gas or CO2 price.36
Finally we have the valuation model. For our DCF analy-
sis it is simply a discount rate, which has been specified to
be 10% per year. For MBV we have time discounting and
state risk discount factors. The time discounting is determined
by a constant real risk-free rate of 3% per year. The pattern
of state risk discount factors is driven primarily by the risk
discounting built into the CO2 and gas forward prices.37 Note
in Figure 1 that, just as the proportional amount of uncer-
tainty in the CO2 prices approaches a constant over longer
periods of time, so does the discounting of risk.38 The same
is true of gas forward prices. Therefore, as shown in Figure 2,
the per-period average discounting for risk in the prices goes
down as we look over longer periods of time. As we show
in the Appendix, state variables that are not correlated with
overall economic uncertainty, like the basic no-test amount
of gas needed, do not contribute to the risk discounting in a
state-pricing valuation.
Static DCF vs MBV. We begin with a decision model where
Gascom must commit now to its future courses of action. It
can perform the well test now if it wishes and use the resulting
information before committing. This provides a comparison
between single-rate DCF and a slightly enhanced form of
forward pricing MBV without the complications caused by
future flexibility.39 It is the type of analysis that would result
if Gascom framed its decision model as “in what year should
we build the CCS facility?” Later, we will add back flexibility
using a CDTA analysis.
Table 1 shows the value obtained for various choices that
could be made with respect to pre-investment, the well test,
the injection scheme, and the timing of startup. If the well
test is done, there are three start times, one for each of the
36. The amount of gas needed for any given asset design will be determined by the
structure of the storage reservoir, and will not be affected by the economy. The uncer-
tainty in the amount of gas needed for this particular activity is too small to influence
the economy as a whole.
37. As we show in the Appendix, some basic market consistency conditions constrain
the state risk discount factors so that the relevant forward prices are at the “center” of the
distribution of state prices in the same way that expectations are at the center of a prob-
ability distribution. In the model we use, the risk discount factors are such that the state
prices have the same proportional spread around the forward prices for gas and CO2 as
the probability distribution for the actual prices around their expectations.
38. Recall that a commodity forward price is the price discounted for risk (forward
price = expected price * risk discount factor). Therefore, flipping this relationship around,
the risk discount factor is the ratio of the forward price to the expected price. It is this
ratio that approaches a constant (roughly 0.56) in Figure 1.
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
possible amounts of the gas needed to run the facility. If there
is a choice to be made between the basic (B) and enhanced
(E) injection schemes, the choice is indicated. Each possible
combination of these control variables is called a “policy” and
is valued separately. The single value assigned to the CSS facil-
ity is the maximum found after a search over all policies. Table
2 shows the value of the CCS opportunity and the optimal
policy in all of the cases we shall consider: DCF vs. MBV, cap
and trade vs tax, pre-committed policies vs. full flexibility.
Consider first the DCF and MBV results under cap and
trade with pre-committed policies. The first decision that
Gascom must make is whether to pre-invest in the CCS
facility. This decision involves a tradeoff between spending
a certain $10M today and saving a possible $30M in the
future. The DCF analysis discounts the $30M savings at a
10% corporate-wide discount rate, whereas MBV discounts
it at the economically consistent discount rate, which for this
known cost is the risk-free rate of 3%.40 As shown in Table 2,
the optimal startup time is 2016 under MBV and 2021 under
DCF, making the actual tradeoffs as follows:
(1) under DCF: spend $10M today to save a value of
$30M * e-10%*16, or $ 6.1M.
( 2) under MBV: spend $10M today to save a value of
$30M * e-3%*11, or $ 21.6M.
This comparison reflects the bias of DCF against spending
now to save later—a bias that can be attributed primarily to
DCF’s discounting the future savings at an inappropriately
high rate.
This bias appears again in the choice of injection design:
basic with DCF and enhanced with MBV. DCF suggests that
you not spend money on the injection design to save future gas
costs. MBV suggests you should. The main cause of this differ-
ence is that the long-term savings in gas cost are undervalued
by the 7% discount rate for risk used in the DCF analysis.41 In
Figure 2, we can see that the appropriate average risk discount
rates for gas falls from 7% per year for very short-term gas to
1.5% per year for 20-year gas, as compared to the constant
7% per year rate applied by DCF. The overdiscounting of
long-term cash flows in markets with long-term equilibrium
forces is a pervasive bias in single-rate DCF valuation.
The decision not to do the well test is the same in DCF
39. We actually use a slightly subtle combination of general state pricing and forward
pricing to do the valuations here. The cash flow model is non-linear even in this decision
model with pre-commitment, because the gas cost once the facility is operating is the
uncertain gas price multiplied by the uncertain gas amount. However, in any given state
about the amount of gas needed (so that the amount of gas becomes fixed), the cash
flows are linear in the CO2 and gas prices and we can use forward pricing methods to
determine the value contingent on that asset-level state occurring. We then use state
pricing methods to take the probability–weighted sum over the gas amount states of
these values to get the overall value. As noted above, because the uncertainty in the
gas needed is not correlated with overall economic uncertainty, there is no further risk
discounting in this probability-weighted sum.
40. A model with uncertain startup costs would not change the essential insights, if
the uncertainty were not too large.
41. The 7% DCF risk premium arises from a total DCF discount rate of 10% less the
3% risk-free rate for time.
55
Table 1 Results of DCF and MBV Valuation with no Future Flexibility

  DCF - Cap and Trade or Carbon Tax MBV - Cap and Trade MBV - Carbon Tax

Value if Invest Best Year Value if Invest Best Year Value if Invest Best Year
Build basic facility $ 6.65 M 2021 - $ 3.09 M 2018 127.09 2013

Pre-Invest+basic $ 3.50 M 2018 $ 7.86 M 2016 141.05 2012

Well Test+basic $ 2.47 M 2020, 2021, 2022 - $ 2.36 M 2016, 2017, never 127.27 2012, 2012, 2013

Pre-invest + Well - $ 0.32 M 2017, 2018, 2019 $ 7.14 M 2014, 2016, 2017 141.54 2011, 2012, 2013
Test+basic
Build enhanced faciliy $ 6.41 M 2021 - $ 2.92 M 2017 128.13 2013

Pre-invest + $ 3.25 M 2018 $ 8.31 M 2016 142.33 2012

Enhanced
Well Test + Basic or $ 2.47 M B2020, B2021, B2022 - $2.21 M B2016, E2017, never 128.48 B2012, E2012, E2013
Enhanced
Pre-invest + Well Test - $ 0.32 M B2017, B2018, B2019 $ 7.23 M B2014, E2015, E2016 142.84 E2011, E2011, E2012
+ Basic or Enhanced
Best Policy Build basic facility in 2021 with no Build enhanced facility in 2016 with Build enhanced facility in 2011, 2011,
pre-investment, no well-test pre-investment, no well test 2012 with pre-investement and the well
test

Table 2 Values and Policies without and with Future Flexibility

Approach and Regime: No Contingency Full Flexibility

Value Policy Value Modal Policy

DCF - Cap and Trade $6.65 Build basic 2021 $10.00 Build basic 2014-2030

DCF - Carbon Tax $6.65 Build basic 2021 $6.75 Build basic 2019-2024

Preinvest, well test, build enhanced

MBV- Cap and Trade $8.31 Preinvest, build enhanced 2016 $13.59
2012-2017
Preinvest, well test, build enchanced in Preinvest, well test, build enhanced
MBV - Carbon Tax $142.84 $143.80
2011-2012 2010-2015

and MBV, so the last difference to discuss is the difference
in the optimal timing of the startup: 2016 with MBV, 2021
with DCF. The tradeoff here is the value of the operating
cash flow you gain by building the facility vs. the time value
of delaying the expenditure of the startup costs. DCF under-
values long-term CO2 for the same reasons it undervalues
long-term gas. And the net effect is that DCF undervalues the
long-term potential operating cash flows of the CCS facility,
which biases DCF toward a later startup. DCF also overvalues
the time value of delaying the startup costs by using a 10%
discount rate instead of the appropriate rate of 3%, creating a
further bias toward a later startup date. Finally, DCF suggests
that you not pre-invest, which makes the startup cost higher
than with MBV. And this in turn has the effect of increasing
the value of delay even more.
Is the difference between the suggested actions with DCF
and MBV important? Using the DCF policy, the MBV value
would be a negative $4.7M, which is $13M less than the value
using the MBV policy.
What happens if CO2 regulation is accomplished through
the carbon excise tax? By design, the expected cash flows of
the tax are the same as under cap and trade regulation. The
DCF values depend only on the expected cash flows and not
on their uncertainty, and hence they do not change from
the cap and trade results. On the other hand, MBV assigns
a higher value to the revenues for the CCS facility under tax
regulation because the revenues are certain and hence risk-
free. And for this reason, startup occurs earlier under MBV,
and the well test gets done because more gas is used (and can
be saved by doing the test) with the earlier start.42
In this analysis, we have several examples of a general
result that we cannot emphasize enough. The change in

56 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
Figure 2 Discount Rates of Risk: DCF versus Forward Pricing
Discount Rates for Risk
0.10
0.09
0.08
0.07
0.06
Rate (1/year)
0.05
0.04
0.03
0.02
0.01
0.00
2005 2010 2015 2020
valuation approach from DCF to MBV changes not just the
value estimates in spreadsheets, but the decisions that should
be taken to realize the most value possible.
Adding in flexibility. Table 2 also shows how the values and
policies change with DCF and MBV under the two types
of regulation when we move to the fully flexible decision
model. As we discussed earlier, the non-linearity arising from
flexibility requires the analyst to consider the entire distri-
bution of drivers and not just their expectations or forward
prices. To estimate the distributions, we simulate 100,000 to
800,000 CO2 and gas price path realizations.43 The discrete
gas amount probabilities are handled directly.
Figures 3, 4, and 5 show the pattern, for the first 10,000
price path realizations, of the DCF and MBV choices in 2013
and the MBV choices in 2021, assuming cap and trade regula-
tion, pre-investment in 2005, and no other action by the time
of the choice.44 The different regions on the graph represent
different combinations of CO2 and gas prices for which a
particular policy is optimal. For example, in the region colored
by the dark gray dots, it is optimal to continue waiting.
42. Because the well test is done, there are three startup designs and times, one for
each possible gas needs state. The enhanced design is recommended in all states. The
timing is 2011 in the low-needs state and 2012 in the others.
43. A look at a given single price path in this sample would reveal that because
the prices are built up probabilistically over time, these paths are not smooth. They do
mimic the sorts of continuous yet jagged patterns you see in most past time series of
economic data.
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
CO2
gas
DCF
2025 2030 2035 2040
Term
The analysis produces this data for each year for all
possible states of the CCS asset45 and therefore allows us
to calculate the probability of being in any given state and
taking any given action in any given year. Figure 6 shows
the probability for the timing of the set of actions leading to
startup that are most likely for the DCF and MBV analy-
ses under cap and trade and tax regulation. For example,
the black solid and dashed lines show the probability in any
given year, using the optimal DCF policy under cap and trade
and tax regulation, respectively, of building the basic facility
without doing the well test (the only option with significant
probability under DCF). The equivalent green lines are the
probability under MBV for doing the well test, which is the
most likely action under MBV (76% under cap and trade,
close to 100% under tax regulation). The gray lines show the
probability of following up the test under MBV with building
the enhanced facility, which is again the most likely choice
(66% under cap and trade, 94% under tax regulation).
We can see from this figure that, with DCF-CDTA, the
value of flexibility stems almost entirely from the responsive-
44. The optimization techniques used to find these choices are based on the work of
Longstaff and Schwartz (2001). The algorithms and the presentation methods used were
developed with Mike Paduada and Mike Samis while David Laughton Consulting Ltd.
had an alliance agreement with the Mining and Metals Group of Amec Americas Ltd.
45. The plots are best viewed as a time-lapsed animation to give an idea of what
might happen with the asset.
57
 Figure 3 MBV-CDTA under Cap and Trade Figure 5 DCF-CDTA under Cap and Trade
Choices in 2013 if Choices in 2013 if
Preinvestment Made/No Other Action Yet Preinvestment Made/No Other Action Yet

Gray = Wait Black= Test Green = Basic Start Light Gray = Enhanced Start Gray = Wait Black= Test Green = Basic Start Light Gray = Enhanced Start
16 16

14 14

12 12
Natural Gas x($/mcf)

Natural Gas x($/mcf)

10 10

8 8

6 6

4 4

2 2
0 5 10 15 20 25 30 35 40 45 50 0 5 10 15 20 25 30 35 40 45 50
CO2 Price ($/tonne) CO2 Price ($/tonne)

Figure 4 MBV-CDTA under Cap and Trade ness of the start-up timing to the natural gas and CO2 prices.
Choices in 2021 if This responsiveness produces a spread in the start-up time
Preinvestment Made/No Other Action Yet probability distribution around the 2021 start for the static
decision model. This spread is relatively narrow in the case
Gray = Wait Black= Test Green = Basic Start Light Gray = Enhanced Start
of tax regulation, where gas prices are the only uncertainty
16 in play. It is broader for the cap and trade regulation. Indeed,
with cap and trade, there is a 15% probability under the DCF
14 recommended policy that the CCS facility is never built.
The MBV-CDTA story is more complex. Recall that the
12 optimal policy to follow under the static decision model is
to pre-invest and then build the enhanced facility in 2016
Natural Gas x($/mcf)

10
without doing the well test. With flexibility, the most likely
action is to do the test earlier on and then build the enhanced
8
facility. However there are significant probabilities of other
sequences of actions leading to startup.
Let us now return to the plots of optimal action in
6
terms of the prices (Figures 3, 4, and 5). As can be seen in
all the plots, given low CO2 prices, it is optimal to wait to
4
see whether it will be worthwhile in the future to build the
CCS facility. At high prices it pays to build the facility and
2
0 5 10 15 20 25 30 35 40 45 50
begin storing CO2. A region of prices where testing is optimal
CO2 Price ($/tonne) occurs only with MBV and only in the early years, in states
where CO2 prices are moderate (and the costs of delaying
the availability of storage are low) and gas prices are high,
making gas savings from testing more valuable. The CCS
design pattern makes sense as well: early on in the asset life
and with high gas prices, it is best to invest in the enhanced
facility to save gas costs.

58 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
Figure 6 Probability of Action Over Time
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2005 2010 2015
Time
Note finally that the DCF biases against spending now to
save or enhance later (no well testing and smaller enhanced
facility regions) remain very evident in the flexible analysis,
as they were in the pre-committed analysis.
Conclusions from the Case. This case shows the power
of MBV-CDTA analysis to support decision-making about
asset design, selection, and management. It also makes clear
the biases inherent in the single-rate DCF approach to valua-
tion and the importance of getting all the models used in
the valuation right. The importance of a formal treatment
of flexibility is shown by the change in the recommended
management policy from no testing to a high probability of
testing. The importance of getting the uncertainty model
right is shown by the very large differences between the cap
and trade and the tax analyses. Finally, this still relatively
simple example shows the limitations of the most commonly
proposed real options approaches. There is no way that this
opportunity could be shoehorned into an analysis based
on a typical financial instrument analogy, and the flexibil-
ity is much too complex to be treatable as an add-on to a
non-flexible version of the asset, even if the right version of
the non-flexible asset could be identified.
Organizational Benefits of MBV-CDTA
In order for valuation to provide a level playing field, it must
be done in a logical and consistent fashion rather than tailored
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
dcf cap 1
dcf tax 1
mbv cap test
mbv cap test 2
mbv tax test
mbv tax test 2
2020 2025 2030 2035
to particular features of a given project or investment. MBV-
CDTA supports this requirement, as well as the desired
division of labor between headquarters and operating manag-
ers, by offering the technical method to pursue a transparent,
divide-and-conquer approach to project evaluation.
MBV is consistent with the principle of “value additivity,”
which underpins the ability to consider assets one-by-one as
well as attributing different components of assets to one or
another strategic source of value. It also allows the corporation
to separate the analysis of economy-level drivers from the analy-
sis of local asset-level technical and commercial drivers that are
influenced by asset managers. And of course, MBV shows how
to combine the separate analyses into a single result.
Additionally, breaking up asset evaluation into four
distinct tasks—decision modeling, cash-flow modeling,
uncertainty modeling, and valuation—clarifies where the
opportunities are for different groups to offer their input.
We would expect a company’s modeling approaches—and
its modeling of economy-wide uncertainty in particular—to
be managed by the corporate center. A centrally supported
valuation platform could include a common set of probability
distributions and state prices for an array of economy­-level
drivers that are relevant to a particular business. One can
imagine in the not too distant future a shift from PC-based
spreadsheet models with risk plug-ins to a web-based system in
which the probability distributions and state prices for the core
59
uncertainties facing a given company are provided centrally.
At the same time, the separation supported by
MBV-CDTA would allow the local operating managers to
focus on their technical and business expertise instead of
trying to master advanced financial concepts. This stands
in marked contrast to many real options methods, which
are not amenable to separation into an economy-wide versus
asset-level split. In our hypothetical web-based platform, local
analysts could model technical and commercial aspects of the
projects “on top of” the centrally provided information.
In particular, local operating managers are responsible
for information about asset-level variables. As we show in
the Appendix, unless one of these variables is correlated with
economy-wide developments, it makes no direct contribution
to risk discounting. Therefore, local operating managers do
not need an expert understanding of how financial markets
price risk and how to estimate risk discount factors. It is
only the central finance unit that owns the economy-level
uncertainty model for the corporation that must develop
this expertise.
This division of labor quite closely matches the division
implicit in DCF where risk adjustments are rolled into a
centrally determined discount rate and cash flows are modeled
locally, ideally with central oversight or peer review. It also
is consistent with practice in firms that have adopted a more
formal decision-theoretic perspective, but it integrates much
better with the core finance function than is often the case
with such approaches. As a result, for the majority of firms
it preserves the existing division of labor and work flow and
thereby minimizes difficult political and cultural elements of
change. For firms whose process is either totally centralized
or operates completely on a case by case method, it provides
a roadmap toward a more desirable approach, one that allows
asset teams or business unit managers to develop the set of
decision alternatives to be formally analyzed and “own” the
modeling of asset-level uncertainties, central finance staff
to specify a standard treatment of economy-level risks, and
senior management to specify a common valuation approach
to ensure consistency and facilitate governance. Yet it is
general enough to avoid myriad special cases.
Beyond its role in fostering a practical division of labor,
MBV-CDTA further gives analysts the flexibility to model
assets in a way that matches and illuminates the actual
decisions at hand. It provides a powerful decision model,
clearly showing which alternatives become optimal under
which circumstances. This emphasis on matching the struc-
ture of the decision is most clearly visible in Figures 3, 4,
and 5 of the Gascom case study, which show the “zones” of
future states where different actions and investment alterna-
tives become viable. MBV-CDTA supports clear thinking
and open dialogue by preserving distributions of outcomes
as well as expected values, emphasizing decision points, and
calling attention to which uncertainties are most critical
60 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
when making current and future choices. One can easily
imagine revisiting these analyses periodically as the underly-
ing drivers evolve to see which alternatives have become more
or less attractive. This provides a forward-looking window
into future business decisions that helps managers retain the
organizational readiness required to exploit real options and,
when warranted, to close down future options that no longer
appear viable.
Finally, our approach increases the visibility and transpar-
ency of key assumptions, which is critical to communication
and organizational buy-in. It also brings the valuation of risk
to the foreground, forcing much more explicit consideration
of which drivers are priced and which are not and highlight-
ing the interaction between local and global variables.
While the method we have presented is applicable to any
set of asset decisions, the required investment in the develop-
ment of understanding and tools is most easily justified for
projects involving: (1) enduring assets (particularly those with
different lives across alternatives); (2) future decisions that
depend on the evolution of key variables; and (3) technical,
contractual, and fiscal non-linearities. Although these features
are prominent in virtually all valuations and choices in oil
and gas and other natural resource investments, they are also
common in tangible and intangible “platform” investments
in manufacturing and service industries.
Some readers may be left wondering: Do we have to do
all of this at once or can we gradually wade into this approach
to valuation? As we mentioned early on, the management
of change is not the focus of this paper. Nevertheless, we
do want to say in answer to this question that the break-
down of the changes into those relevant for implementing
MBV and CDTA separately mean that an organization can
implement them sequentially in either order if that suits its
circumstances. Moreover, there is no need for a discrete shift
from current practice to a complete implementation of either
MBV or CDTA. There is scope for gradual movement, both
technically and organizationally, on either front toward what
we propose.
Conclusion
We have presented a general alternative to single-rate DCF
called MBV that adjusts for risk at the level of the individual
cash flow realizations instead of aggregate cash flows. MBV is
an implementation of the time-state pricing basics that under-
pin virtually all modern valuation approaches. It provides
more accurate valuations for all but the simplest assets.
We have also shown that we can complement MBV with
a more complete decision tree framework called CDTA that
increases the “richness” or realism of the modeling environ-
ment. Recent improvements in computational methods (and
computing power) make this approach feasible for assets
with a realistic degree of complexity, as we have shown in
the Gascom example. As a valuation tool, the combination
of MBV and CDTA dominates those real options approaches
that model assets restrictively as analogies to traded finan-
cial instruments or that treat limited forms of flexibility as
add-ons to a static asset model.
The key advantages of the method from a valuation
perspective are numerous. Most important, by going back
to basics in the pricing for risk, it allows market-based risk
adjustments for all types of uncertainty on all elements of
the cash flows. MBV-CDTA can also readily accommodate
non-linearities in the cash flows, thus overcoming the well
known biases in DCF.
Like many back-to-basics approaches, MBV-CDTA
tends to transform implicit assumptions into explicit ones.
We appreciate that the increased transparency comes at a
cost of increased complexity. We would argue that the
complexity is “out there” in the business environment, and
the valuation approach merely reflects it. A major advantage
of MBV-CDTA, however, is that its structure encourages,
indeed requires, a divide-and-conquer mentality. This
provides more levers for corporate managers to pull, and
requires more consistency on the part of project champi-
ons. The CDTA component takes into account the value of
flexibility that these champions sometimes try to reflect in
nebulous claims of “strategic value.” Overall, MBV-CDTA
actually allows the corporate center to increase its influence
over the evaluation of asset decisions while at the same time
increasing the use of asset-level expertise.
david laughton is the Principal at David Laughton Consulting Ltd,
and an Adjunct Professor in the School of Business at the University of
Alberta.
raul guerrero is Managing Partner at Asymmetric Strategy LLC.
donald lessard is Epoch Foundation Professor of International
Management at the MIT Sloan School.
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
Appendix: Some Further Details on State Pricing
In the body of the paper, we considered the implementation
issues with MBV-CDTA, providing a minimum of vocabulary
and technical detail. In this Appendix, we delve deeper into
two issues: first, the frictionless (or perfect) financial markets
approximation and its implications for the role of valuation
in decision-making; and, second, the basics of state prices.
This is done with an eye towards helping readers answer some
of their own, and their colleagues’, “yes, but…” questions.
Other important issues must await treatment elsewhere.
These include many details of how to specify and param-
eterize usable “industrial strength” decision, uncertainty, and
valuation models, and how to perform, as required by CDTA,
the complex searches for a best decision.
The bulk of asset pricing theory is built on the approxi-
mation that financial markets are frictionless. This is not
because anyone believes that real markets lack frictions such
as transactions costs, information asymmetries, and barri-
ers to the creation of markets or the quick equilibration of
prices. Rather, it is because there is currently no complete
approach for handling these frictions, and the conjecture is
that their effect on valuation is small compared to other types
of approximation errors, such as those in the cash flow and
uncertainty models.
We believe the current best practical solution to account
for market frictions is to split the analysis of value into a strict
valuation portion based on the perfect market approximation
and an “enterprise risk management and other considerations”
portion. As we expand on below, on the strict valuation side,
frictionless markets lead to value additivity, and projects,
defined properly, can be considered on a stand-alone basis.
On the enterprise risk management side, new projects must
be considered in light of the company’s existing and poten-
tial portfolio of assets, and at least some attempt is made to
account for the effects of frictions on value.
As we discussed in the body of the paper, valuation
produces a ranking of projects and actions within projects,
not just numbers. It is possible the company may choose to
overrule this ranking given the concerns that stem from finan-
cial market frictions. For example, a common complaint of
senior managers against valuation is that it can suggest taking
the project that risks $100M in order to produce a net value
of $12M over the project that risks only $50M to produce a
net value of $9M. The validity of this complaint, with which
we have some sympathy, is based entirely on the consideration
of market imperfections. In this particular case, managers may
be worried about difficulties in raising capital, which would
not be an issue if there were no financial market frictions. Or
they might be worried about the risk of a costly bankruptcy,
again an issue only with imperfections. Hence, their intuition
to choose the smaller, less valuable project might be right if the
larger project would crowd out other valuable opportunities by
starving them for capital, or if a $100M loss could bankrupt
61
the company (or give customers, suppliers, or shareholders
reason to doubt its future solvency). However, the discussion
would be moot if the value of the $100M alternative were
either $9.01M or $200M, and not $12M. Issues arising from
market imperfections for a $100M investment would likely
be worth more than $0.01M, and while they might be worth
as much as $3M, they are almost surely not worth as much
as $191M. Valuation provides a screen to allow the organi-
zation to focus on tough risk management calls, where the
risk management must be done with real assets as opposed to
financial engineering.1
We believe it is important not to blur the line between
valuation and enterprise risk management. We would recom-
mend management conduct “clean” valuations of both
projects, unfettered by ad hoc devices such as artificially high
discount rates to penalize the capital intensive project. Once
the valuations are complete, additional considerations can
be weighed, including the implications of asset decisions for
enterprise risk management, the costs of transmitting appro-
priate information about “private risks” to financial markets
(and the implications of those costs for the availability of
capital), and the management issues of information sharing,
incentive alignment, and control. As there are no comprehen-
sive, useable quantitative models to deal with these issues at
this time, we believe they are best handled using qualitative
judgments about the use of the value estimates, or at best by
semi-quantitative adjustments to them such as scorecards. In
particular, attempts to quantify the impact of market imper-
fections by using a corporate utility function (Smith and Nau
1995, Borison 2005a) as a metric for decision-making are
ill advised. Corporate utility is an ad hoc device without
theoretical foundation that is not connected with the real
economic and organizational issues that arise from financial
market frictions. Its use tends to obscure the complex issues
that are involved.
The job of valuation, then, whether it be DCF, EVA,
real options, or MBV-CDTA, is to estimate the value of
project cash flows under the assumption of frictionless finan-
cial markets. Under this assumption, trading takes place to
enforce the “Law of One Price”: assets with the same cash flow
consequences have the same price. A corollary of the Law of
One Price is the Principle of Value Additivity: the value of a
collection of cash-flow claims is the sum of the values of the
individual claims. This principle allows us to partition the cash
flows associated with a particular complex asset into different
parts associated with simpler assets, value each of the simpler
assets separately, and then sum the resulting values. Value
1. Resource constraints other than capital, particularly human resource constraints,
may be another important reason for overruling the choice dictated by the stand-alone
value calculation. We would argue this is a case of incomplete modeling. The portfolio
of projects should be selected subject to the constraints the company faces. It is almost
always the case that the company cannot staff up immediately to meet all opportunities.
Hence, it is appropriate to consider project value relative to the size and capability of the
project management team. But our main point stands—the valuation should be carried
out first, including the opportunity cost (or shadow price) of constrained resources to the
62 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
additivity is the formal principle that allows an analyst to
value a bond by separately valuing each cash flow, for example.
Although this separation by time is the most common applica-
tion, there is no reason why cash flows cannot be segregated
into components and valued separately, as suggested by Myers
with the adjusted present value approach. And of course, value
additivity also allows us to value cash flows state-by-state.
A good way to think about the law of one price is to
remember that cash flows inside the company are the same as
cash flows outside of the company. Did you just immediately
disagree with that statement in your mind? If you did, you
probably jumped to a scenario where the company “needs
the cash,” but this is an enterprise risk-management/market
imperfection consideration which valuation always explicitly
sets aside. For valuation, the cash flows from a real asset are
a commodity that can be diversified with cash flows from
financial assets. If this can be done in frictionless markets,
technical risks that are not affected by, and do not affect,
the overall economy can be completely diversified away. That
is, we can combine the cash flows from the purely technical
project with financial assets until the variance of the resulting
portfolio is negligibly small. On the other hand, pervasive,
market-wide risks, such as oil and gas prices, interest rates, or
stock market performance cannot be diversified away.2 Most
people are risk-adverse, and hence the variance associated with
these economy-level risks must be compensated via some sort
of risk premium.
Corporate decision-makers often struggle with the
prescription to value purely asset-level risks with no risk
premium—equivalently, to discount them with the risk-free
rate. The reaction is understandable, since we seem to be
equating the variability in those technical outcomes that have
purely local asset-level effects—for some companies the aspect
of their business they spend the most time understanding and
attempting to influence—with a sure thing such as the payoff
for a government bond. The variability in asset-level outcomes
does “matter.” A 52% chance of technical success is always
better and more valuable than a 51% chance of success. But
the effect of this variability on value is completely described
by the probability of outcomes for the technical uncertainty
and requires no further adjustment for risk.
To understand this result, consider a state variable defined
by the amount of oil in place in a small field. The states for
this variable are determined purely in physical terms.3 What
is happening in the economy has no influence on it, as it was
determined long ago, and the outcome of the variable is too
small to have an influence back onto the overall economy.
extent these can be estimated (a topic we shall not address here), and other consider-
ations should be weighed outside of the valuation framework.
2. Specific groups of assets can be hedged against each other to yield cash flows with
no variance. Given the positive correlation between assets, this is usually achieved by
going long some assets and short others. On an aggregate basis, however, all assets that
exist are “net long” and the logic of hedging cannot be applied economy-wide.
3. Oil in place is different from reserves, which is a mixed physical-economic con-
struct, and, as such, less useful for analysis.
How would an investor price a bond that pays $1000 a year
from now if the amount of oil is high (the “success bond”)
and another similar bond that pays off if it is low (the “failure
bond”), where high and low are defined so that there is a 50-50
probability of either happening? Under these circumstances,
both bonds are economically identical to an arm’s length inves-
tor, with each offering an expected payoff one year from now
of $500 in situations where there is no difference in overall well
being. Therefore they should have the same price.
Two big misunderstandings arise when a manager oversee-
ing the particular field in question considers these bonds. First,
the manager may object that the outcome of these bonds is
perfectly correlated with his personal well being. That may be
true, but of course he is charged with running the company
for the benefit of its owners, not for his personal gain.4 The
shareholder owners are diversified in their holdings and there-
fore break the correlation between the field outcome and their
personal wealth. Second, the asset-level risk under consider-
ation may potentially bankrupt the company. In that case,
we are back to our original suggestion: value the oil-in-place
bonds using consistent principles—in this case, as we shall see
shortly, using no risk premium to account for the amount of
oil in the field. Then, adjust for the market imperfection of
costly bankruptcy.
For the arm’s-length investor, we have determined that the
two oil-in-place bonds are identical in effect, and their value
must be equal. Since together the two bonds give a risk-free
payoff one year from now, the sum of their value must be
$1000 discounted for time alone. Hence, the value of each
bond must be $500, or 1000 times the probability of success
or failure respectively, discounted for time. This is the formal
way to show that there is no additional risk adjustment in the
valuation due to technical uncertainty. This sort of argument
can be generalized to situations where there are many mutually
exclusive and exhaustive states with different probabilities. It
can be further generalized to look at risk adjustment in states
characterized by both asset-level and economy-level variables.
In that case, the risk adjustment for the combined state is
equal to the risk adjustment for the economy-level variables
by themselves.
We now outline how the risk adjustments for economy-
level variables can be estimated using observed market
variables.
The general state pricing formula is:
V = Σ overall times t of interest
(Σ over all states ‘s’ at time t
(cash flow in state s * probability of state s *
risk adjustment for state s) *
time discount factor for time t )
4. There is clearly a management control issue here. Board members and senior
executives must design appropriate incentives for the manager to bring his actions in line
with what shareholders would like.
Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
To simplify the following discussion, we limit ourselves
to a single time period. The simplest claim to value in this
single time period is one that pays a constant, say $5, in every
state, such that:
V = $5 * time discount factor * Σ over all s (probability of
state s * risk adjustment for state s)
However, we also know that the value of a claim that pays
$5 with certainty is just $5 * time discount factor. Therefore,
it must be that:
1 = Σ over all s (probability of state s * risk adjustment
for state s)
The product of the true probability of state s occurring
and the risk adjustment for each state s is a positive number
and these numbers sum to one. These are the defining proper-
ties of a probability distribution. Therefore we call this product
the risk-adjusted probability of the state. It is useful terminol-
ogy to call any statistic, such as an expectation, derived using
this distribution a risk-adjusted statistic.
What other constraints do we have on the risk-adjusted
probabilities? If we consider a general cash-flow, CF, which
varies by state and occurs at time t, the state pricing equation
tells us that the value of a claim to CF is:
V = Σs (CF in state s * risk adjusted probability of s
occurring) * time discount factor for time t
= risk-adjusted expectation of CF * time discount factor
for time t
But recall that this value is also the forward price for the
cash-flow discounted for time. Combining these two relation-
ships, we find that the forward rice for any cash-flow is just its
risk-adjusted expectation. Because of this, any forward price
directly observable from market data (like the short-term
gasoline forward prices in the battery car example) or calcu-
lated in some other way (like the GDP index forward prices
or the long-term gasoline forward prices to which we referred
in the body of the paper) puts another constraint on the risk-
adjusted probability distribution. For many uncertainty and
valuation models in current use, the whole of the risk-adjusted
probability distribution can be estimated once we know the
real distribution and the risk-adjusted expectations of all of
the state variables.
We show how this all works out in a simple little example
of the natural gas market over one time period. In our model
of the market there are three states: one state now and two
equi-probable states a year from now. In one state a year from
now, the price is higher than expected. In the other it is lower.
The prices are as follows:
Price in One Year
$14.50 with 50% probability, or
$9.50 with 50% probability
63
 Further assume that the gas forward market gives a
one-year forward price of $11.25 and that the one-year time
discount factor (TDF) equals 0.95. This is all the informa-
tion we need to estimate the state risk adjustments and state
prices. The risk-adjusted probabilities of the up state and the
down state will sum to one, so if the risk adjusted probability
of the up state is q, the risk adjusted probability of the down
state will be (1-q). The risk adjusted expectation must equal
the forward price:
Forward Price = Σs (CF in state s * risk adjusted
probability of s occurring)
Forward Price = $11.25 = ($14.50) * q + $9.50 * (1-q).
We can now solve for q and get:
q = 35% and 1-q = 65%
It is often the case that we work directly with the risk-
adjusted probabilities, but we can also easily extract the state
risk adjustments and the state prices from these:
risk adjustment for the up state
= risk adjusted probability of up / true probability
of up = 70%
risk adjustment for the down state = 130%
We can complete a “round trip” around discount factors
to show how all of this ties together. The ratio of the forward
price to the expected price is the overall risk adjustment factor:
$11.25 / $12.00 = .9375. Recall that the risk discount factor
multiplied by the time discount factor equals the overall
discount factor you may be most used to working with. Total
discount factor = .9375*0.95 = 0.8906. To get the correspond-
ing discretely compounded one period discount rate: 0.8906
= 1 / (1+k avg), k avg = 12.28%.
The overall discount rate for the up state is: 70% * 0.95
= 1/ (1 + kup ), kup = 50.38%. The overall discount rate for the
down state is: 130% * 0.95 = 1/ (1 + kdown ), kdown = -19.03%.
How do we interpret a negative discount rate? It is a premium
the market is willing to pay in order to ensure that cash flows
arrive in the down state. Note that neither of the state discount
rates is remotely close to the “about 10%” discount rate used
so frequently in capital budgeting.
Most of the literature deals in state prices rather than risk
adjustments, but these are a final small step away. The value
today of a claim to $1 in the up state equals the probability
of getting the $1 multiplied by the total discount factor, so:
50% * $1 * 1/(1+50.38%) = $0.3325. The corresponding
state price for the down state is $0.6175. We can double check
these results by recalling that the state prices should sum to
the time discount factor, which they do:
0.3325+0.6175 = 0.95
and that they should reproduce the forward price of gas
discounted for time, which they also do.:
5. This is the source of “the power to the time t” formulation of a multi-period dis-
count factor in DCF analysis.
64 Journal of Applied Corporate Finance • Volume 20 Number 2 A Morgan Stanley Publication • Spring 2008
 = 0.3325 up state price X $14.50 gas in up + 0.6175
V
down state price X $9.50 gas in down
= $10.69 = $11.25 * 0.95
As we mention in the body of the paper, if forward prices
are not available, we can use an asset pricing model such as the
CAPM to estimate a forward price, then proceed as above.
So now we know what to do in one period with one
simple type of uncertainty with an approximation of two
end-of-period states. What about multiple states, multiple
variables, and multiple time periods?
Dealing with multiple states and multiple types of uncer-
tainty does not require any new basic concepts, just more
mathematical and modeling detail.
Dealing with multiple periods requires one more idea,
which we only sketch here. The basis of compound interest is
the observation that, in a world without uncertainty, holding a
multi-period bond is the same as holding a series of one-period
bonds where the proceeds of each one-period bond are “rolled
over” into buying the next. The law of one price then requires
that the price of the multi-period bond be the product of the
one period prices.5 There is a generalization to this in a world
of uncertainty represented by multi-period generalizations of
the one-period tree we just discussed. In such a tree, any state
price for a state s several periods into the future is just the
product of the one period state prices for the states on the
path in the tree that lead to the state s. If we can model the
one period state prices as we just did above, we can therefore
determine all of the state prices on the tree.
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