Decision-Making Allowing for Uncertainty of Future Investment Opportunities

Abstract

All capital investment decisions are made under varying degrees of risk and uncertainty. Evaluations of the desirability of capital investments require estimates of present conditions as well as forecasts of future events which involve these risks and uncertainties. Several recently developed models for capital investment decision-making have involved the random variable treatment of anticipated cash flows. When present worth calculations are made in these cases, a fixed interest rate is usually assumed. When internal rate of return calculations are made, the minimum acceptable rate of return is given a fixed value. This paper treats the minimum attractive rate of return (used with present worth calculations) and the minimum acceptable internal rate of return (used with internal rate of return calculations) as stochastic variables having subjective probability distributions. This procedure takes explicit account of the uncertainty of future investment opportunities. It is shown that, under certain circumstances, significant differences in the values of the mean and the variance of the criteria for making the investment decision are obtained when the results of this procedure are compared with results using the usual deterministic interest rate or minimum acceptable rate of return.