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Adjusting for Risk in the Capital Budget of a Growth-Oriented Company
Published online by Cambridge University Press: 19 October 2009
Extract
Although the importance of evaluating the risk of potential investments has long been recognized, only recently have formulations been developed to include risk as an explicit variable in the decision-making process. The considerable progress being made in this area, both in theory and in application, is attested to by the number and variety of contributions to the literature.
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- Copyright © School of Business Administration, University of Washington 1968
References
1 A list of recent contributions includes: Lintner, John, “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics XLVII (February 1965), pp. 13–37CrossRefGoogle Scholar; Naslund, Bertel, “A Model of Capital Budgeting Under Risk,” Journal of Business XXXIX (April 1966), pp. 257–271CrossRefGoogle Scholar; Robichek, Alexander A. and Myers, Stewart C., “Conceptual Problems in the Use of Risk-Adjusted Discount Rates,” The Journal of Finance XXI (December 1966), pp. 727–730Google Scholar; Sharpe, William F., “Risk Aversion in the Stock Market: Some Empirical Evidence,” The Journal of Finance XX (September 1965), pp. 416–422CrossRefGoogle Scholar; Swalm, Ralph O., “Utility Theory—Insights into Risk Taking,” Harvard Business Review 44, No. 6 (November–December 1966), pp. 123–136Google Scholar; and Van Home, James, “Capital Budgeting Decisions Involving Combinations of Risky Investments,” Management Science 13, No. 10 (October 1966), pp. B–84–92.CrossRefGoogle Scholar
2 See, for example, Lerner, Eugene M. and Carleton, Willard T., A Theory of Financial Analysis (New York: Harcourt, Brace & World, Inc., 1966), Chapter 3.Google Scholar
3 For a summary of the origin and the limitations of the marginal cost concept, see Quirin, G. David, The Capital Expenditure Decision (Homewood, Ill.: Richard D. Irwin, Inc., 1967), pp. 112–114Google Scholar. The principal objection to this approach is illustrated by this example. Suppose a firm for which the cost of equity capital is 12 percent has a potential investment guaranteed to yield 5 percent, which investment can be financed completely by a bond issue at a cost of 4.8 percent. It is not prudent financial policy to accept such: a proposal. Once the borrowing capacity of the firm is exhausted, all investments must be financed with high-cost equity capital. Under those conditions, the firm will be forced to reject investments offering a certain return of 10 percent.
4 Several views are summarized in Cohen, Jerome B. and Robbins, Sidney M., The Financial Manager (New York: Harper & Row, 1966), Chapter 22.Google Scholar
5 Solomon, Ezra, The Theory of Financial Management (New York: Columbia University Press, 1963), p. 75.Google Scholar
6 For simplicity we have disregarded the costs of flotation of debt and equity securities. Inclusion of such costs will raise the cost of capital slightly, but will not have any effect on the central theme of the argument.
7 Swalm, op. cit., pp. 135–136.
8 The formulation by William F. Sharpe, op. cit., is ei = p + bσi in which (ei, σi) are the parameters of the distribution of rate of return i, p is the pure interest rate and b is a risk premium demanded. To convert the foregoing to our use of cash flows, let I be the amount of investment, and x be the random variable cash flow. Then 
. Substituting in Sharpe's equation yields 
.
9 Swalm, op. cit.
10 This follows directly from the modified Sharpe equation. A similar concept was proposed in Baumol, William J., “An Expected Gain-Confidence Limit Criterion for Portfolio Selection,” Management Science 10 (October 1963), pp. 174–182CrossRefGoogle Scholar. Baumol suggests limiting the efficient set of portfolios to that subset for which x* = E − bs (in our notation) is a maximum.