BUSF_A01.qxd

Attitudes to risk and expected value

Figure 6.7
Graph of the
probabilities of
the NPV for two
projects each
having equal
expected NPVs

Although both projects have identical expected NPVs, the ranges of possibilities differ

between them. A risk-averse investor would prefer Project A. This is because the worst

possible outcome is an NPV of £9,000, which is quite a lot higher than the minimum outcome

from Project B.

would be more attracted to Project B. A risk-neutral investor would be unable to dis-

tinguish between these two projects.

Expected value and the business’s investment decisions

From what we have seen above, in deciding on risky investment projects we cannot

directly translate the wealth maximisation rule into one of expected wealth maxim-

isation: in other words, we cannot simply take on all available projects with a positive

expected NPV. The reason for this is that shareholders are probably all risk-averse.

The situation is complicated still further by the fact that they probably show different

degrees of risk aversion (differently shaped utility curves and different levels of

wealth). An investment with a risk/return profile that might be acceptable to one

shareholder may not be acceptable to another.

This potential lack of unanimity may seem familiar. It is, of course, analogous to the

investment decision without the borrowing/lending facility (a matter that we dis-

cussed in Chapter 2), and it poses the same problem. How do managers make their

investment decisions when shareholders take different attitudes to risk? As before, it

is really the utility, or satisfaction of wealth, that shareholders want maximised, but

shareholders will not necessarily all agree on what satisfies them most. Maximisation

of the utility of wealth involves some consideration of the range of possible outcomes

(as is evident from Figure 6.5).