The cost of risk due to project permanent shutdown: A DNPV perspective

The cost of risk, a central concept of the Decoupled Net Present Value (DNPV) method, quantifies risks in monetary terms in a consistent and transparent manner. Within the DNPV framework, the cost of risk represents the monetary compensation investors receive for bearing identified investment risks. One of those risks—the risk of permanently stopping at any stage of a project cycle—is ubiquitous and yet not explicitly included in standard financial valuation methods with a customary practice of incorporating all risks in a single variable (i.e., the discount rate), and thus are not equipped to deal with individual risks. Novel general expressions are derived to calculate the cost of risk due to permanent shutdown during the initial sequential investment and revenue-generating phases. The permanent shutdown occurs due to a random event described by a binomial distribution. Closed-form solutions for simplified cases are derived from the general expressions to illustrate how the cost of risk varies with time during the investment and revenue-generation phases. A simple example of an investment in the development of a pharmaceutical drug is presented to illustrate how the derived expressions can be used to effortlessly complement a standard financial valuation with the proposed risk-based valuation.