(A) study on the capital budgeting of risky interrelated investments : Total expected utility approach

Abstract

The established approach to risk analysis in the capital budgeting may be classified into three categories. One is the simulation approach. The other is the chance-constrained programming approach. The third is the expected utility approach developed by Frederik S. Hillier. The expected utility approach uses the present value and the expected utility of present value as the criteria in order to choose the best combination from the group of proposed investments. But, not only the present value for the approved set of proposed investments but also the present value for the existing investments resulting from past decision determine the utility that matters. This paper presents the total expected utility approach which supplements the shortcoming of the expected utility approach that cannot consider the existing investments. In this paper, the total expected utility approach uses the present value(for both approved set of proposed investments and existing investments) and the total expected utility of present value as the criteria to determine the best combination of risky interrelated investments to approve. In addition, this paper deals with the probabilistic cash flow problem and proposes to integrate the theoretical and practical aspect of it. The problem of autocorrelation and crosscorrelation of the cash flow is investigated. Finally, a hypothetic case is given with the computer program for the solution procedure.