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Capital investment appraisal: a new risk premium model
Author(s) -
Baker Rose,
Fox Roland
Publication year - 2003
Publication title -
international transactions in operational research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.032
H-Index - 52
eISSN - 1475-3995
pISSN - 0969-6016
DOI - 10.1111/1475-3995.00398
Subject(s) - actuarial science , valuation (finance) , net present value , capital budgeting , investment (military) , time horizon , economics , risk premium , financial risk , context (archaeology) , financial risk management , risk management , present value , business , microeconomics , financial economics , finance , project appraisal , paleontology , production (economics) , politics , political science , law , biology
Net Present Value (NPV) is the principal valuation model of the financial literature. Firms are accordingly directed, as a matter of good practice, to adopt the model for selecting investment projects, yet questionnaire surveys show that the adoption rate has been very slow and the quality of usage questionable. In particular, alternative risk measures are popular amongst practitioners. In this paper we remodel the treatment of risk in the NPV model based on assumptions that seem realistic in an organizational or operational, as opposed to a personal, investment context. We derive formulas for calculating: the appropriate discount rate, a ‘risk horizon’ (where the risk premium exceeds the expected value), and a maximum default hazard point for projects. These measures provide a rationale for non‐NPV approaches to risk measurement in questionnaire responses and offer a practical benefit to investors.