Evaluation for Risky Investments

The first approach, the application of the capital asset pricing model to capital investments, relates the acceptance of a project to the systematic risk of investors. Projects are evaluated in a market context, and the required rate of return is computed for each project. The method was illustrated with an example.

A problem of incompatibility between the usual measures of return for stocks and for capital investment projects can be reduced by expressing project returns in terms of changes in capitalized value. Still better, a publicly traded proxy company can be used in the calculation of beta for the project under review. When the firm finances partially with debt or when a proxy company uses more or less leverage, it may be necessary to modify the capital asset pricing model approach. An adjustment formula for beta was illustrated, as was the calculation of a weighted average required return for a project. The principal implication of the CAPM approach is that investors are able to diversify away all residual risk on their own. The firm's diversification of capital investment projects is therefore not a thing of value. Instead of the CAPM, the implications of using the arbitrage pricing theory for estimating required returns was explored. It was concluded not to be practicable at this time, but to bear careful watching.

The second approach we used evaluates projects with respect to their incremental impact on the total return and risk of the firm. Here one is concerned with various combinations of existing investment projects and investment proposals under consideration. In a portfolio framework,’ the tradeoff between risk and expected value of net present value for different combinations of investments can be analyzed. Management then can choose the best combination of risk and return for the firm as a whole. This approach has particular value in the case of a privately held company.

In an attempt to reconcile the two approaches under real world conditions, we saw the capital asset pricing model's dependence on several assumptions, one of which is perfect markets. When we allow for the cost of bankruptcy as well as for other market imperfections, residual risk becomes a factor of importance. In such cases, a dual system for evaluating risky investments can be used where both the capital asset pricing model and the total variability approaches are employed.

Finally, we presented the evaluation of single investment projects without reference to either systematic risk considerations or considerations of the impact of the project on the total risk of the firm. Here management makes a decision to accept or reject a project on the basis of the expected value and standard deviation of the distribution of possible returns. Because of the reasons cited, the link to stock price is far from direct, and the approach accordingly suffers. Still, it is used, and it represents a step toward increasing sophistication in the evaluation of risky investments.