Thursday, September 9, 2010


Utility Theory and Capital Budgeting

On the basis of figures of the expected values and standard deviations, it is difficult to say whether a decision maker should choose a project with a high expected value and a high standard deviation or a project with a comparatively low expected value and a low standard deviation. The decision makers’ choice would depend upon his risk preference. Individuals and firms differ in their attitudes towards risk. In contrast to the approaches for handling risk, utility theory aims at incorporation of decision makers’ risk preference explicitly into the decision procedure. In fact, a rational decision maker would maximize his utility. Thus, he would accept the investment project, which yields maximum utility to him.

Risk attitude

As regards the attitude of individual investors towards risk, they can be classified in three categories.
  • Risk-averse investors attach lower utility to increasing wealth. For them the value of the potential increase in wealth is less than the possible loss from the decrease in wealth. In other words, for a given wealth or return, they prefer less risk to more risk.
  • Risk-neutral investors attach same utility to increasing or decreasing wealth. They are indifferent to less or more risk for a given wealth or return.
  • Risk-seeking investors attach more utility to the potential of additional wealth to the loss from the possible loss the from the decrease in wealth. For earning a given wealth or return, they are prepared to assume higher risk.
It is well established by many empirical studies that individuals are generally risk averts and demonstrate a decreasing marginal utility for money function.

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