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Effect of Uncertainty on Interest Rates

As the level of uncertainty rises (meaning that the risk is greater), we add more to the capitalization interest rate.

For example, instead of adding 5%, we will add 8%. The increased interest rate will reduce the present value. On the other hand, when the level of uncertainty falls (meaning that the risk decreases), we add less to the interest rate.

For example, if we add only 1%, the present value will be greater. By adding to the interest rate, we translate the level of uncertainty into an amount of money deducted from the present value obtained in a state of absolute certainty.

A Few Percent More

As mentioned before, as our doubts regarding future income rise, we increase the percentage added to the capitalization interest. Unfortunately, no one can provide an accurate, or even a semi – accurate percentage that should be used. Every expert will cite a different interest figure.

While models have been developed over the years to help calculate the proper percentage to add, the real business world is so complicated and unexpected that a theoretical calculation can only provide a crude estimate.

In practice, until you learn the models and understand and try them out, you should get help from experts. Present the projects to them, and ask their opinions about the appropriate capitalization interest. In most cases, the added percentage will vary between 3% and 10%, and generally between 3% and 5%.