The Derivation of the NPV Probability Distribution of Risky Investments with Autoregressive Cash Flows

Abstract

Frederick Hillier’s (1963) seminal paper was probably the first to propose the use of probabilistic information to assess risk in the process of capital budgeting. However, such an approach to investment decision was short-lived when Sharpe published his 1964 paper, supplemented by Lintner’s (1965) and Mossin’s (1966) articles, thus setting the conceptual ground for what was to become the modern capital asset pricing model (CAPM). Even Hertz’s (1964) simulation methodology and Wagle’s (1967) statistical analysis of risk in capital investment projects did not fare better. In fact, all the probabilistic approaches to risky investment decisions were swept away by the Sharpe-Lintner-Mossin CAPM revolution as it became the creed of modern financial theory. Such a result was unavoidable given that, under the capital asset pricing theory, the dispersion (as well as the higher moments) in the probability distribution of future cash flows became an irrelevant statistic. Systematic risk, as calculated by the beta, became the only relevant measure of risk.