An Approach to Risky Project Valuation Integrating Decision Analysis and Capital Asset Pricing Model

Janny Yu

Abstract

One of the biggest challenges in risky project valuation problem is often finding accurate models of cash flows and uncertainties so as to compute the net present value (NPV) of each project for comparison. Although managerial flexibility is not a new concept, existing work on the decision analysis perspective on real options has been limited, even though decision trees as a tool itself instinctively models project flexibility

Our thesis reviews various risky project valuation approaches across different fields of study and from which devised an integrated method which incorporates concepts from both decision analysis and finance theories and can be readily implemented. Our proposed approach clarifies an appropriate method to account for the time value of money and market uncertainties and at the same time, overcomes the typical problem of having to find a replicating portfolio in the securities market in most finance methods. Applicable in both complete and incomplete markets, the integrated method produces consistent results as compared to other more complex approaches, helping to solve a simple valuation problem faster and easier.

Finally, we show that with appropriate modification and application, decision tree can be readily used as a tool for project valuation. By implementing a simple visual depiction of sequential events, our approach provides a hassle-free alternative method for risky project valuation.