On Evaluation of Risky Investment Projects. Investment Certainty Equivalence

TL;DR

This paper introduces a new methodology for evaluating and ranking risky investment projects using the Omega measure, explicitly analyzing risk profiles without relying on risk-adjusted discount rates, supported by an illustrative example.

Contribution

It proposes a novel investment evaluation approach based on certainty equivalence and the Omega measure, offering explicit risk profile analysis without ad-hoc risk-premium assumptions.

Findings

The methodology can rank projects of different types, scales, and durations.

It explicitly analyzes risk profiles using the Omega measure.

The approach differs from conventional RADR-based methods.

Abstract

The purpose of the study is to propose a methodology for evaluation and ranking of risky investment projects.An investment certainty equivalence approach dual to the conventional separation of riskless and risky contributions based on cash flow certainty equivalence is introduced. Proposed ranking of investment projects is based on gauging them with the Omega measure, which is defined as the ratio of chances to obtain profit/return greater than some critical (minimal acceptable) profitability over the chances to obtain the profit/return less than the critical one.Detailed consideration of alternative riskless investment is presented. Various performance measures characterizing investment projects with a special focus on the role of reinvestment are discussed. Relation between the proposed methodology and the conventional approach based on utilization of risk-adjusted discount rate (RADR) is discussed. Findings are supported with an illustrative example.The methodology proposed can be used to rank projects of different nature, scale and lifespan. In contrast to the conventional RADR approach for investment project evaluation, in the proposed method a risk profile of a specific project is explicitly analyzed in terms of appropriate performance measure distribution. No ad-hoc assumption about suitable risk-premium is made.