Project Valuation Under Incomplete Capital Markets: The Case of Non-Diversified Entrepreneurs

Abstract

Traditional project valuation usually overlooks the important risk analysis process because it relies in the complete market assumption. In a complete market it will be possible to either find twin securities or elaborate a dynamic investment portfolio to replicate the project risk and payoff in every state of nature at any moment in the future. Furthermore, since one assumes well-diversified investors what matters is the project value as if it were traded in the capital market. Unfortunately, the assumption of complete markets hardly holds in reality, especially in emerging markets full of illiquid securities and where financial mechanisms such as short sales or buying on margin are prohibited or non-existent in practice. In this work one assumes incomplete markets and designs a risk analysis procedure that can be applied whenever there is no tradable benchmark in two situations: when investors hold a well-diversified investment portfolio and when investors are non-diversified entrepreneurs. The former case is important because during the last decade there has been an increase of foreign direct investment in emerging economies, so some global diversified entrepreneurs have put their money in these markets. The latter case is especially important for emerging markets where a high proportion of total enterprises are family business or are owned by a single non-diversified entrepreneur. In either case it is possible to use a clear cut investment rule, such as the Net Present Value, but there is no a single market value for the project. In the case of global diversified investors it is just one possible value and for non-diversified entrepreneurs what matters is the project value given the project total risk that they face.