Thursday, September 16, 2010


Benefits and Limitations of Utility Theory

The utility theory approach to risk analysis in capital budgeting has certain advantages. First, the risk preferences of the decision maker are directly incorporated in the capital budgeting analysis. Second, it facilitates the process of delegating the authority for decision. If it is possible to specify the utility function of the superior- the decision marker, the subordinates can be asked to take risks consistent with the risk preferences of the superior.

The use of utility theory in capital budgeting is not common. It suffers from a few limitations. First, in practice, difficulties are encountered in specifying a utility function. Whose utility function should be used as a guide in making decisions? For small firms, the utility function of the owner or one dominate share holder may be used to guide the decision making process of the firm. Second, even if the owners’ or a dominant share holders’ utility function be used as a guide, the derived utility function at a point of time is valued only for that one point of time. Third, it is quite difficult to specify the utility function if the decision is taken by a group of persons. Individuals differ in their risk preferences. As a result, it is very difficult to derive a consistent utility function for the group.

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