Warning: Original content by blog author ahead
It's standard corporate finance practice to calculate the value of future cashflows as the expected cashflow divided by a risk-adjusted discount rate.
Suppose you have a project that delivers one year from now a $1 billion gain with 50% probability and a $1 billion loss with 50% probability, so that its expected cashflow is 0. This is an extremely unattractive proposition given its high risk and zero expected reward, but following the usual practice tells us that the value of this cash flow package is 0, since 0/(1+r) = 0 for any r that is not -1. So the discounted cash flow method tells us that we are indifferent between having this gamble and not having this gamble!
How do we reconcile this result with the fact that we would actually be willing to pay a large sum to avoid taking on this gamble?
Blog comments are temporarily open, or you can email me (my address is on my personal homepage). Prize for a correct answer is immortal glory via mention on this blog.
UPDATE: You can find a hint here.