A GLUM Primer: How to Account for Risk with Uncertain NPVs
This note describes a method for adjusting uncertain future cash flows into a present certain equivalent. The use of net present value (NPV) to adjust a stream of future known cash flows into a single-value equivalent adjusted for the time value of money is common practice. The use of simulation to produce a risk profile of NPV values is also now common. While the expected net present value (ENPV) is often used to convert a risk profile of uncertain NPVs into a single-value equivalent, this approach ignores risk and the decision maker's attitude toward risk. Simply put, a 50% probability of receiving an NPV of $1 million is not as attractive as a 100% chance of receiving an NPV of $500,000. The general logarithmic utility model (GLUM) constructs a single certain equivalent from a risk profile (i.e., a "risk-adjusted NPV") which goes beyond ENPV to incorporate risk aversion into the decision-making criterion. The simplicity and many attractive properties of the GLUM prompt us to suggest it as more attractive than other ways to adjust an NPV risk profile for risk.