A Theory-of-The-Firm Perspective on Discount Rates Formulation in Investment Valuation

Abstract

The paper offers some considerations on investment project valuation from an entity-firm perspective. Once recognised the role of firm’s complementarities, uniqueness, path-dependent decision-making, bounded-rationality and organizational processes, a different approach to investment projects valuation and selection management arises, which is different than that proposed by standard finance theory and based on CAPM. Standard finance theory, according to CAPM, identifies risk as the standard deviation of a project’s expected returns, and claims that only systematic risk must be considered. The entity-firm perspective, on the contrary, defines a different concept of risk (the Negative Whole Risk) and calls for considering the whole risk of the project and the expandability of the firm’s opportunity set. A Minimum Acceptable Rate of Return for alternative investment projects must be set, that takes into account a project’s whole risk and the expandability of the firm’s opportunity set. A role for active risk analysis and management processes is clearly recognised, and the innovative capabilities of the firm are introduced so superseding the market completeness assumption upon which is based the standard finance theory. An analysis is offered, that focuses on the main determinants of the Minimum Acceptable Rate of Return for investment project valuation. From the entity theory perspective a new interpretation emerges of some phenomena, such as the role of financial slacks, the underinvestment effect and the importance of the whole risk related to the project. In the new perspective Minimum Acceptable Rates of Return are endogenously and subjectively set, and they act more as organizational control tools than as a tool for the fair valuation of investment projects. Finally, different rates act as reference points for the investing side and the financing side.