Features of the Project and Risk Premium in Investment Decision Making

Abstract

The goal of the paper is to find out how significant can be the impact of the project features (such as term structure of payments or degree of operating leverage) on risk premium size in investment decision making. To calculate a fair risk premium for specific risks of the project we use a decision-making criterion on the basis of value-at-risk (VaR). The size of premium is estimated by Monte-Carlo simulation methods for a number of contingent projects that differ from each other either by term structure of payments or operating leverage. The results of our calculations show that the size of a specific risk premium is largely determined by the degree of operating leverage, but practically does not depend on term structure of payments. The results obtained in this paper are based on the assumption that managers act in accordance with the criterion of equality of VaR for the project future payments and for the future value of the best alternative investments. The paper discusses the possibility of using the VaR criterion and Monte-Carlo simulations in corporate practice for evaluating investment decisions. Unlike the traditional NPV method when market risk is set exogenously via the project beta, the simulation modeling allows to find out the market alternative with risk that equals to the risk of the project. The originality of the research lies in the application of a new criterion for investment decision making, which takes into account the company’s tolerance to risk. Based on this criterion, it is possible to justify the use of markups to a discount rate, which is often done by companies in practice.