Discounting Expected Values with Parameter Uncertainty

In valuing future cash °ows standard practice is to take the current cash °ow and then extrapolate at an expected growth rate, which can vary at di®erent points in time. This practice stems form the standard way of dealing with time value of money problems under certainty. However, with uncertain cash °ows this practice underestimates the expected cash °ows when the growth rates are serially correlated. As a result, both value and the equity cost, calculated as an internal rate of return, are biased low. Given the prevalence of serial correlation in the economy this paper demonstrates how to incorporate the e®ects of serial correlation in a simple way and demonstrates by way of a simulation that the e®ects can be signi ̄cant. As a result, it casts doubt on the usefulness of several standard valuation approaches and results.