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Models of Capital Budgeting, E-V VS E-S*

Published online by Cambridge University Press:  19 October 2009

James C. T. Mao
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Extract

Markowitz's [2] portfolio selection model was originally concerned with financial investments, but the model's implications for capital budgeting are now well recognized. Markowitz's basic idea is that the optimal portfolio for an investor is not simply any collection of good securities, but a balanced whole, providing the investor with the best combination of “return” and “risk.” Return and risk are to be measured by the expected value and variance of the probability distribution of portfolio return. Although financial writers have generally accepted Markowitz's measure of return, they have not been completely satisfied with his suggested measure of risk [1]. In fact, Markowitz himself had reservations about choosing variance as a measure of risk.1 Besides variance, he considered five other alternative measures of risk:

(1) The expected value of loss;

(2) The probability of loss;

(3) The expected absolute deviation;

(4) The maximum expected loss; and

(5) The semivariance.

Type
Financial Management
Information
Journal of Financial and Quantitative Analysis , Volume 4 , Issue 5 , January 1970 , pp. 657 - 675
Copyright
Copyright © School of Business Administration, University of Washington 1970

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References

[1]Baumol, William J., “An Expected Gain-Confidence Limit Criterion for Portfolio Selection”, Management Science, 10 (October 1963), pp. 174–182; and Nevins, Baxter D. “Leverage, Risk of Ruin and the Cost of Capital,” Journal of Finance, 22 (September 1967), pp. 395–403.CrossRefGoogle Scholar
[2]Markowitz, Harry M., Portfolio Selection (New York: Wiley, 1959). Markowitz had also written an article on the same topic which was published in the Journal of Finance in 1952. The article, however, did not produce the same impact that his book produced seven years later.Google Scholar
[3]Strotz, Robert, “Cardinal Utility”, American Economic Review, 43 (May 1953), pp. 390–391.Google Scholar
[4]Swalm, Ralph O., “Utility Theory—Insights into Risk Taking”, Harvard Business Review, 44 (November–December 1966), pp. 123–136.Google Scholar
[5]Tobin, James, “Liquidity Preference as Behavior Towards Risk”, Review of Economic Studies, 67 (February 1958), pp. 65–86. Reprinted in Hester, Donald D., and James Tobin, eds.Risk Aversion and Portfolio Choice (New York: Wiley, 1967).CrossRefGoogle Scholar