Company’s investment decision under uncertainty: Risk management approach

Abstract

The practice of investment projects analysis in companies often does not comply with the theory’s recommendations; everywhere the companies add markups (risk premiums) to the fair return required by shareholders when calculating NPV of project. The size of the risk premium is chosen almost arbitrarily. The main goal of this paper is to propose the model that will help to explain the entering of specific risk premium to discount rate in NPV-rule and to calculate the size of this premium. We suppose that risk-averse managers make investment decision taking into account both the market risk and specific risk of the project. Based on the theory of decision-making under uncertainty, we introduce two new criteria for investment decisions and propose two behavioral models. Both models are dealing with a single isolated project and company that is entirely funded by equity capital. It is necessary to analyze which additional factors (debt, other projects, risk tolerance, competitive environment, availability of real options of the project) can affect the risk premium. The proposed models can be a methodological basis for investment decision making, but to use them in practice, it is necessary to evaluate correctly the level of a specific risk of the project. Although these behavioral models describe the decisions of managers but they can be applied to the analysis of investment decisions of capital owners.