Uncertainty and Capital Investment Decisions
Uncertainty is often incorporated into capital investment decisions by adjusting the discount rate. Adjusting the discount rate is a useful technique for sensitivity analysis, but discount rate adjustments may not adequately address the relative uncertainty of projects. This paper examines an alternative strategy which is based on probability theory and the analytical framework of the Capital Asset Pricing Model (CAPM). The advantage of the Capital Asset Pricing Model is that the variability in the return stream and the timing of the return stream are directly considered in the analysis. The results of the CAPM analysis can then be used to compare alternative projects and strategies.
KeywordsCovariance Income Volatility
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