284 NPV PROBABILITY DISTRIBUTION OF RISKY INVESTMENTSof bankruptcy caused by any failure to meet legal debt claims. Under the
MM assumption of perfect and costless contracting:
the problems that crop up when a firm becomes close to financial distress dis-
appear because the firm can always costlessly recapitalize itself so that it is no
longer close to financial distress. In the real world, such costless recapitalization
is a dream. As a result, total risk matters and has to be taken into account when
a firm evaluates a project. (Stulz, 1999: 9)When a risky investment project imposes an additional cost on a financially
strained firm through an increase of its total risk, the decision makers must
quantify the marginal increase in total risk. To take this cost into account,
managers have to quantify their total risk and have to understand how a
new project might impact the firm’s total risk. Being close to action, man-
agers have bothex anteandex postinformation advantage over shareholders
and debtholders. They might therefore try to maximize their own welfare
(as any typically rational person might do) at the expense of shareholders
or debtholders. However, given appropriate incentives (this is what stock
options aim at), managers will take decisions to the shareholders’ advantage.
However, when projects go astray, shareholders will hold project managers
responsible for the failed project and will certainly not think about blaming
the economy’s systematic risk for its failure, the more so when the firm is in
financial distress. The probability of loss then becomes important informa-
tion, not as a criterion but as a constraint, in the selection and management
of investment projects. Contrary to the concept of systematic risk which is
drawn from a normative paradigm, the concept of total risk is derived from
a positive probabilistic paradigm and aims at assessing the effective prob-
ability of loss. Therefore, it is just comes as a logical consequence that the
hurdle rate that should be used to assess investment projects in a positive
probabilistic paradigm should not be the CAPM prescribed cost of capital
but the effective weighted marginal cost of capital of the firm.
The cost of total risk depends, among other things (a) on how the project
is incorporated or organized, and (b) on how the firm is financed. The con-
ventional capital budgeting practice is to include the project within the firm.
Such a practice may not always be efficient considering that the credit risk
supported by creditors is related to the firm’s total risk, rather than just the
project’s risk. Given that creditors have claims against the entire firm, this
implies the obligation to assess the firm’s total portfolio of projects’ and oper-
ations’ risks, a costlier operation than assessing the risk of a single project
(Shaw and Thakor, 1987). Furthermore, incorporating the project within the
firm creates an asset substitution moral hazard whereby cash flows can be
diverted from safe projects to riskier ones at the creditors’ expense. Unless
covenantspreventsuchsubstitution, creditorswouldrecognizesuchamoral
hazard and adjust the marginal cost of capital accordingly thereby impact-
ing the total risk of the firm. On the other hand, organizing the project as