Capital investment appraisal: a new risk premium model

Capital investment appraisal: a new risk premium model

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Article ID: iaor20042473
Country: United Kingdom
Volume: 10
Issue: 2
Start Page Number: 115
End Page Number: 126
Publication Date: Mar 2003
Journal: International Transactions in Operational Research
Authors: ,
Keywords: queues: applications
Abstract:

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 the 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.

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