American Finance Association

Market Risk Adjustment in Project Valuation Author(s): George M. Constantinides Reviewed work(s): Source: The Journal of Finance, Vol. 33, No. 2 (May, 1978), pp. 603-616 Published by: Blackwell Publishing for the American Finance Association Stable URL: . Accessed: 15/01/2012 16:46
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determination of the optimal capital structure of a firm. We motivate the discussion of this paper by briefly examining a forerunner to our valuation rule. Then we discount all expected cash flows at the riskless rate of return as if the market price of risk were zero. The paper is organizedas follows: Section II states the assumptionswhich lead to Merton's(1973) intertemporal CAPM. is given by the single period Sharpe-Lintner capital asset pricing model (CAPM) as X X-(RM-RF RANPV(X )==+RF )cov(RM X)/aM Essentiallythis formula states that the expected cash flow X is adjusted to its certainty equivalent X. the certainty equivalence approach to evaluating a stream of cash flows. the certaintyequivalenceapproachresemblesour valuationrule.X)/a. Three examples are consideredin section IV where the rule is applied to the valuationof an asset. In section V we generalizethe rule to controlledprocessesand apply it to a cash management problem.In section VI we provideconcludingremarks.THE JOURNALOF FINANCE VOL. continuous time framework. *Carnegie-Mellon University Graduate School of Industrial Administration. Indeedit will be apparentlater in the paper that the certaintyequivalenceapproachis a special case of our valuationrule. the rule is applied in two steps as follows: We first replace one or more of the model parameters by their "effective values" in a specified way. Pittsburgh. "effective value" X. and cash management.(RM. the risk-adjusted net present value RANPV(X) of the cash flow X. realized at the end of the period. 2 MAY 1978 MARKET RISK ADJUSTMENT IN PROJECT VALUATION GEORGE M. CONSTANTINIDES* I.X)/ am and is then discounted at the 603 . 15213. XXXIII.(RM. as if the marketprice of risk were zero. option pricing. The certaintyequivalenceapproachmay also be viewed as follows: The expected cash flow X is first adjusted to its risklessrate of returnRF. In section III we define the problemand derive the valuation rule in the simplest case.RF)cov(RM. Given a valuation problem in an intertemporal. THIS PAPER DEVELOPS A RULE INTRODUCTION which reduces the problem of valuation in the presence of market risk to the problem of valuation in a world where the market price of risk is zero. NO. and the determination the optimal capital structureof a firm. Viewed in this way. the pricing of a of europeancall option.applicability of the valuation rule is illustrated through the diverse examples of asset valuation.RF)cov(RM. The broad. In a single period model. which is subsequently dis- countedat the risklessrate of return. Pa.RF.

as developedby Merton (1973).. a. and Dependingon the interpretation the project. with state dependentreturnsare in agreement independent.Investorshave homogeneousexpectationsregarding the investmentopportunity set. a.604 II. securitiesare infinitelydivisible. Perfect Markets The securitiesof firmsare tradedin a perfectcapital market.r = aiM/M (1 wherethe subscriptM refersto the marketportfolioand A-(aM . Projects .which is held by a firm. We shall be studyingprojectswhich are tradedby firmsin a perfectmarket.also satisfiesthe CAPM equilibrium relationship(1).r> (aM . the of c) Mertonassumedthatfirmspay no dividendsand accomplish transfer cash to shareholders We throughsharerepurchase.2.We assumethat firmsmay also issue debt. This result follows from Merton's(1973) theorem 1.therefore. Some minor differencesbetween Merton's and madehereare noted. set It set (1977) that the assumptionthat the opportunity is non-stochastic may be replacedby the weaker that the efficientfrontier(and not necessarily entireinvestment the assumption opportunity is state set) with the latterassumption. Under these assumptions. We now prove that the returnof any project. Investor Preferences Each investormaximizeshis strictlyconcaveand time-additive utilityfunctionof consumptionover his lifespan. and the varianceof returnper unit time. The Journal of Finance THE CAPITAL ASSET PRICING MODEL The assumptions which lead to the intertemporal CAPM. a. A. short sales of all securities.r)aPM/am. The opportunityset is non-stochasticin the sense that ai. are allowed.investorscan borrowand lend at the same interestrate. Under the assumptionof free 1.we makea distinction betweenthe terms"project" "security". are stated below. Hamada (1969) showed that a firm undertakesa project only if ap . the covariance of returns per unit time auj. where the subscriptP designates the project. C. has been provenin Constantinides B. B. For each security. b) Mertonassumedthat firmsissue only equity. are all nonstochasticfunctionsof time.r)/ aM.In particularthere are no transactionscosts in trading securities. the expectedrate of returnper unit time. and violateassumption that the opportunity is non-stochastic.but which are not necessarilytraded in the capital market. allow dividendsas well as sharerepurchase.and the riskless rate borrowing-lending r. Securities The prices of securities are lognormally distributed.Merton (1973) proved that the equilibriumsecurity returnssatisfythe CAPMrelationship' I) a. The firm realizes a windfall gain if the inequality is strict.Thesedifferences not affect the derivation do assumptions the assumptions of the theorem: a) UnlikeMerton.with full use of the proceeds. and trading in securitiestakes place continuouslyin specificapplications of investorsin the capitalmarketmay or may not be allowedto investin the projectdirectly.2. exist and are finite with ai2>0.there are no taxes. In the next sectionwe shallbe considering projects with state dependentreturns which..

as or a subsystemof the firm.w(t0). t). It is a simplematterto repeatMerton's(1973) derivationin the absence of a risklessasset. We assumethat the state variablex changesin the time interval(t. Assumethat the function V(x. the randomvariablesw(t1) .t.. Equation(1) still obtains.and risk-adjusted cash flows. t) and cash returnc dt. a = a(x.the randomdisturbance the state is normallydistributed of with mean. t) throughIto's Lemma4 as /V(x 2)=( + d+a dV(x. t) which is completelyspecifiedby the state option.wherenow r is interepreted the expectedreturnof the as zero-betaportfolio. the projectwill be interpreted being an investment.the equilibrium price of the projectis sufficientlyhigh so that no firm realizesa windfall gain throughundertakingthe project. t2Therefore. of the time interval[to. The differentiability must be verifiedin every specificapplication. w3) -w(t2). t) =V. chap. ..Market Risk Adjustmentin Project Valuation 605 entry by new firms.our entirediscussionappliesalso to the case wherethere does not exist a risklessasset. t + dt) is cdt.see Breiman (1968).so that the stochasticprocessdefinedby (2) exists. t) has been explicitlyevaluated. We assumethat the functions. . + pL + 2. The projectgeneratesa streamof cash flows and the value of these marketvalue of the projectrepresentsthe time. 10. t + dt) is the sum of capital appreciation dV(x.Then the equilibriumreturnof this projectsatisfies(1). t). tI. In specific applicationswhich appearin later sections. where c = c(x. 4.. .t)dt. and time t. t) and dw is the incrementof a Wienerprocessw(t).t. THE GENERAL MODEL We considera projectof marketvalue V(x.u(x.w(t1). t3 .r. III. t) is twice continuouslydifferentiablew. t + dt) by dx = judt + a dw (2) wherejt = p(x..u(x.t) and a(x. the discussionof the following in sectionswe shall assumethat a risklessasset exists and we shall be referring r as to the risklessrate. are independentand normallydistributed with meanzero and variancetI . A Wienerprocessis definedas follows:For any partitionto < tI < t2 < . We may then writedV(x.. 10.t2.Vxx)dt+ aVxdw Vx (3) 2. One would simplyhave to replaceour referencesto the risklessrate by the expectedreturnon the zero-betaportfolio. a claim on a firm. For a rigorous discussion. The return on the project in the time interval (t. and obtain the continuous-time versionof Black's(1972)CAPM..For the sake'of concreteness.However. 3. any infinitesfor simaltime interval.. t. For a heuristicdiscussionof the Wiener process see Kushner(1971). x and once continuouslydifferentiablew. For a discussionof Ito's Lemmasee Kushner(1971)Chap. oo). w(t2) . respectively. t) satisfythe necessary regularity conditions.tO.t)dt and varianceu2(x. AssumptionA may be relaxed to allow for the case where a risklessasset does not exist.2 We also assume that the cash return generatedby the project in the time interval (t.once the function assumption V(x. .

t) _ (x. i.u* (x. and covariancewith the marketper unit time given by ap = c+V x+2 Vxx )/V(5) and GPM= PuMa Vx/ V (6) where p= p(x.we rewrite(7) as c-rV+ 2 +V. This point will be clarifiedin the next sectionwhereapplications discussedand the boundary are conditionsare explicitlystated. (7) The solution to this partial differential equation which satisfies the relevant boundaryconditionsgives the marketvalue of the project. This procedurewas first used by Merton (1970) in derivingthe differentialequation which is satisfiedby the priceof a europeancall option.for the moment. 6. t) . (9) Consider.6 the boundaryconditionsimposedon V are identicalto those imposedon V.t)+cdt V(x' t) cPM 1/ =vtC c aV a +l+ 2 Vxx)t Vd (4) with expectedvalue per unit time ap.For reasonsthat will be apparentlater.u(x.*+ Vx+ 2 Vx =0 (8) where . The rate of returnon the projectis dV(x.606 The Journal of Finance where V=-aV(x.r = 0 in (7) and obtain the following differential equation for V(x. t) c-rV+ V. of Comparison equations(8) and (8') indicatesthat V(x. We set aM.+ttvx+ a V^ =0? (8') Since the boundaryconditions are independentof the marketrisk premium. t) may be consideredas the marketvalue of the project in a capital marketwhich pays no premiumfor marketrisk.r = 0. .t). aM .u*(x. the project return satisfies the CAPM of equation (1). providedthe drift . t)a(x. Denote by V(x. 5.t) of the state variableis replacedby .Ap(x.e.a capital marketwhich pays no premiumfor market risk. t) is the instantaneouscorrelationcoefficient between dw and the marketreturn. t). We substitute(5) and (6) in (1) and upon intertemporal obtain5 simplification c-rV+ V+ +(t. t)/ at etc. t) the value of the above project in this market. Under the assumptions made in section II.-Xpa)Vx+ = Vxx 0.

(x. t) c~ [k+ V+L + v + a 2 Vxxjdt + aVxdw+ sdz] (4') and equation(7) is replacedby (c-APCS)-rV + V + (tL-Xpa) Vx+ 2g Vxx= ? (7') where p. Step two: Evaluatethe streamof cash flows as if the marketprice of risk were zero. t) . t) = c (x. i. The rule is also easily generalizedto the case where the cash flow generatedby the project in the time interval (t. t) is the instantaneouscorrelationcoefficient between dz and the marketreturn.Changesin the elementsof x satisfy a joint diffusion process such that E(dxi) = .t) where the c *(x.u(x. .Ap. processz(t) which in generalis correlatedwith dw of equation(2). we first replace the drift parameterspi by n. t).The latter equation suggests a slightly generalizedversion of the rule: The drift parameterp. that is to say. where pi and aij are functionsof x and t. Furthermore expectedcash flow rate c(x..e. Equation(4) is replacedby dV(x. discountexpectedcash flows at the risklessrate.(x. t). where c = c(x. t) + cdt sdz 1[ V(x.. t). Upon adjustmentof the drift parameters c we evaluatethe streamof cash flows as if p.t) by ..L*(x. the marketprice of risk were zero.. t).*= i Apimaj. i = 1. = p (x. t + dt) is stochastic and is given by cdt+ sdz instead of cdt. s = s(x. The rule is easily generalizedto the case where the state variablex is a vector x = [x. The rule still holds. Rule Step one: Replace the drift L(x.idt and cov(dxi.Market Risk Adjustmentin Project Valuation 607 This observationsuggeststhe followingrule for determiningthe marketvalue of a project. t) = . (9') Note that the adjustmentfor marketrisk of the drift parameterc(x. t) .u*(x.t) is replacedby c*(x. It is worthwhileto note that the correlation .Xp(x. Proceedingas before we derive the followingdifferential equationwhich is analogousto equation(7) n In c-rV+ VI + (Li-ApiMai) Vi+ 2 Z E = O.x2. t) and dz is the increment of a Wiener p. and ignore market risk thereafter. t)s (x.t) of equation(9) as before..t) is replacedby . t)a (x.x] ratherthan a scalar..t) is formally identical to the correspondingadjustmentof the drift parameterp(x. dxj)= ijdt.

All earningsare payablein cash to the owner of the asset at time T.Upon exerciseof the option. p.the holderof the optionreceivesthe dollarvaluewhichthe foreign securitycommandsin the foreigncapital marketin lieu of the certificateof the foreignsecurity.The securityprice7 7.udt + a dw and jt. T) = x.if jt. Step two: Evaluate the asset as if the market price of risk were zero. p.this securityis not pricedaccordingto the U. capitalmarket.In general. The boundaryconditionis V(x.t by ji* = - Xpc. where with a. t + dt) the asset earnsdx where dx = . .S. The expectedcumulativeearningsat time T are ji* T.transactions constraints.Notice that this boundaryconditiondoes not involve the marketprice of risk. a. which says that at time T. We now apply the rule developed in the last section as follows: Step one: Replace the expected earnings rate . In any time interval(t.and specialrestrictions prohibittradingof the foreignsecurityin the U. Valuation of an Option Cofisidera europeancall option with marketvalue V(x. No interestaccrueson the earningsfrom the time that they are earneduntil the time that they are paid. and the net present value of . Moregenerally. where x is the marketprice of the securityon which the option is written. the analogy with the certainty equivalenceapproachis no longer valid. A. a' constants. The latterassumptionis made in order to simplifythe example. Institutional suchas taxes. which is subsequentlydiscountedat the risklessrate. t) at time t. Valuation of an Asset APPLICATIONS OF THE RULE Consideran asset with lifetimet.For we fluctuations the exchangerate.where the drift parameter.S. p is the correlation coefficientof dw and marketreturn). t). The procedurewhich we have followed may now be related to the certainty equivalenceapproach: t. B. such as a consumerprice index.608 The Journal of Finance between the Wiener processes w(t) and z(t) does not influence the valuation procedure. We denote the cumulativeearningsof the asset at time t by x(t) and the value of the asset by V(x. CAPM.Xpurepresentsthe certaintyequivalentof the expected earningsrate jt. in simplicity disregard More generallythe option may be writtenon some index x. IV. are constant (as before. again the dynamicsof x are givenby dx/x = a dt+ G'dw. Howeverin other applications. a are functionsof time. A feasiblesenariois as follows:An optionis writtenin the U. all cumulativeearningsare paid in cash and the value of the asset at T equals the cumulativeearnings. Also c(t) = 0. Exampleswhich illustratethe usefulnessand generalapplicability the rule are of presentedin the next two sections. We do not assumethat the securityon whichthe option is writtenis necessarily pricedaccording to the CAPM(1).S.* T at time zero is tt*Te-rT Thus the value of the asset at time zero is (tp-Xpa)Te-rT.t may not be interpretedas an earningsrate. on a foreignsecurity. costs. the value of the asset at time zero is e rTfO( t -Xp)dt.

Xpa')x. Price changes are now described by dx/x = a* dt + o'dw. Step two: Ignore marketrisk and discount expectedcash flows at the riskless rate./'2/2)T) (J'~~~~~~(0 .is tradedin the capital market without market imperfections. 0) xoe(a* -r)TN ( ln(xo/E) + (a* + a'2/2) T) ln(xo/ E) +(ca*. T) = max[O. We assume that the firm may take no action at times within the time interval(0.t by j*'p . . Then (10) becomes the familiar Black-Scholes (1973) formulafor the pricingof an option V(x.E] and is independent of the market price of risk. No dividendsare paid. Thus V(x0. a' are constants.TN ( (10) whereN(-) is the standarderrorfunction. The Followingour rule. In the specialcase when the securityon which the option is written. This integral is explicitly evaluated in Sprenkle (1964). date of the option is T and the exercisepriceis E. it is typicalof one-periodmodels of the firm where the firm makes decisions only at the points in time t = 0.Market Risk Adjustmentin Project Valuation 609 is lognormallydistributed. we proceedas follows: Step one: Replace . where a. the appendix. Whereasthe latter assumptionis restrictive. The boundary condition is V(x. O)= erT (XT-E) dF(xT IxO) of distribution x(T) conditionalon whereF(xT I is the probability XO) x(O)= xo.. dx/xx= adt+u'dw. we set c(t) = 0. the CAPM (1) we obtain a -r=Xpa' which implies a*=r. The bond maturesat time t = 1 and the firm liquidatesat the same time. Theory of the Firm and Optimal Capital Structure We consider a firm with equity Ve and a discount bond 8. maturity Since no cash flows are receivedbefore time T.x. 1) such as issuing or buying back equity and debt.i.e. In terms of our earlier notation. where a* = a . O)= xoN ( ln(xo/ E) + (r + u'2/2) T) -Ee-T ln (x?/ E ) +(r - a2/2) T)(1 C.Xpa= (a . and is made here solely for the purpose of illustratingthe applicationof our rule to a particularclass of models of the firm. Vb at time t=0. The solutionof this integralgives8 V(xO.Xpa'. where /t =ax and a=a'x. 1.

Litzenberger Rolfo (1977) have recentlyanalyzedthe absurdity of the application of the one-period CAPM to cash flows which are not normally distributed.Specifically they showed that the implicit assumption of quadraticutility function leads to an optimal capital structureof the firm. and a one-period CAPM is applicableonly under the assumptionthat investors have quadraticutility funcand tions. receivethe remaining wealth the bondholders paid in full and the equityholders are then aftertaxesare paid. before taxes and before of the repayment the bond. a are constant. Gonzalez. particular.defined by dz (t) = . 9. a are constant.a /2 C= z. Second we assume that the randomvariablex(l) is distributedas follows: Let the random variable z(t) be. t)dw z (0) = wheredw is the incrementof a Weinerprocess. Whereas earlier models had ignored the adjustmentof the discount rate for market risk.the distributions Yeand yb are not normal (at best they are truncated normal). For detailed specificationsof Ye(x(l)) and Yb(x(l)) see for example Kraus and Litzenberger (1973)and Baron(1975)for one periodmodelsand Scott (1976)for a multiperiod model. If the firmis unableto meet its obligationto bondholders. t)dt + a(z.Depending on the specific model assumptionsthe firm is liquidatedor reorganized. given some x(l).lnx(1) is normallydistributed and variance a2 We apply our rule to this problemas follows. (1977).610 The Journal of Finance We denote by x(1) the value of the firm assets at t = 1. the firm is declaredbankrupt. where ii. functionsof x(l). jt.We make two assumptions.First we assume that the equity and debt are tradedcontinuouslyover the time interval[0. x(l) is normally distributedwith mean jt and variance a2. respectively.On theoreticalgroundsthis procedureis objectionablefor the following of of reason:Even if the distribution x(l) is normal. If the firmis able to meet its obligationto bondholders. In if This definitionof x(l) coversa wide class of distributions. discounted for time and risk. With costly bankruptcythis adjustmentis computationallycomplex and it typically involves the determinationof partial moments. the stockholdersand bondholdersreceive at time one Ye(x(l)) and Yb(x(l)) respectively.We define x(l) by x(1)= z(1). for which the firm returnsare stochastically dominatedby the returnsof a firm with a non-optimal capitalstructure. equityholders the receivenothing and the bondholders receive the residualwealth x(l) net of bankruptcycosts and possible tax payments. .Withoutdiscussingthe details of these models we may say that. We shall demonstratethat the adjustmentof Yeand Ybfor marketrisk through and applicationof our rule is straightforward free from the fallacies discussedby Gonzalezet al.(z.9 The values of equity and debt at time as zero are then the expected values of Ye(x(l)) and Yb(x(l)). 1]. more recently Rubinstein (1972) and Kim have adjustedthe expectedvalue of Ye and Yb for both time and marketrisk through applicationof the one-periodCAPM. if t = zZ with mean la.

Maintenanceinfluencesthe deterioration of the machine as dx = .t)dw is the only stochastic . we consider V(x. The controlvariableis the rate at which dividendsare paid. Under the assumptionthat IcI< so. dx=[t(x. t). it is the rate at which the firm raises capital. t + dt). V. t)dw. i. VALUATION OF CONTROLLED PROJECTS In generalthe managerof a projectmay influencethe cash flows of the project.u. that is to say.Market Risk Adjustmentin Project Valuation Step 1: We replace . For purposes of illustration we assume that the "project" is the cash of the working capital level. Step 2: We discount Ye and Yb as if the marketprice of risk were zero. because nowhereis it assumedthat investorshave quadraticutilities.The procedureis also computationally simpler than the procedureinvolved in the applicationof the single-period CAPM.+(II-Xpa)Vx+ a Vxx]=O (12) which is an extensionof equation(7). u. considerations of market risk may shift some of the model parameters. where x is some measureof efficiency.t) to be the value of a firmwhich is characterized a single state variable. u.The managerof the machine may choose the time path of u(t) and in this sense he controls the project. Furthermore.the workingcapital by of the firm. u.e. u stands for the cash flows of the equityholders this firm.Xpu. This procedureis free from the criticismof Gonzalez et al. Assume that the machine deterioratesin a random fashion. V(x. Let u(t) be the expenditurerate for maintenanceof the machine. if u > 0. Maintenance also influences the cash flow c(x.(x. but leave the structure of the model and the qualitative implications regardingoptimal capital structure unchanged.t by [* = y . t)dt + a(x. Iul< oo. assumethat the projectis a machinewhich is characterized a we by single state variablex. Xpaand ignoremarketrisk thereafter.x. The argumentwhich follows equation(7) is applicableto equation(12) also. Then our rule specifies that we may replacey by tt* = thus greatlysimplifyingthe discussion. it is shown in the appendixthat V satisfies max[c-rV+ V.Assume that the change of element of this model.As an illustration.u. Then c = u. The problem then is to determinethe maintenancepolicy u(t) which maximizesthe value of the streamof cash flows. Thereforeour valuationrule applies to controlled projecfsas well.t)dt+a(x. As another applicationto a controlled project. We considernext a differenttype of controlprocess and the applicabilityof our rule. Ye= e-rEYe(x(1)) 611 and Yb= e rEYb(X(l)). t)dt generated over (t. if u < 0.our rule provides the following insight to problems in corporation finance: A t least in those cases where the cash flows are normally or lognormally distributed.

The demandfor cash in time (t.high positivecorrelationbetweenthe demandfor cash and marketreturn has the same effect on the parametersof the optimal policy as low expected demandfor cash does. . t) are V(x(t). A fixed cost is incurred each time that bonds are liquidated to increase the level of cash reserves and each time that cash is converted into bonds. xo(t). t) and vSe C st). t) V(x-(t). In other words the effect of marketrisk on the marketvalue costs and on the parametersx(t). t) do not involve the market price of risk: At those well defined instances (x > x(t) or x < x(t)) when it is optimalto adjustthe cash level. and the cash level is not adjusted as long as x(t) < x < 5?(t).u*. t) = K1+ V(xo(t). The boundaryconditionson the functionsV(x. The latter objective ignoresthe adjustment expectedcosts for marketrisk. t) = Vf(x (t).in the sense that it follows a cash managementpolicy with the goal to minimize the present value of the stream of these costs. This model has been extensivelystudiedin the literature'0 underthe assumptionthat the objectiveof the firm is to minimize the time-adjustedcosts of the system. Assume that the cash policy is described by three time dependentparameters > xo(t)> x(t) such that the cash level is adjustedto xo(t) x(t) whenever x > (t) or x< x(t). 11.For example. t + dt) is dx = y dt + a dw. We have limited our discussion to diffusion processes (2) and have ignored discontinuousstochasticprocessesin a continuous-time framework. We show that a straightof forwardapplicationof our rule bridgesthe discrepancy betweenthe two objectives. t) = O. and ignoring market risk thereafter. t) = 4(x. x(t) of the cash policy is fully capturedby replacing the actual drift jt by the effective drift . t)a(x. t) . Then the marketvalue costs coincidewith the time-adjusted expected costs. Let x be the level of cash reservesat time t and V(x. We now apply the rule as follows: Step one: Replace the drift parametert(x. the adjustment cost is deterministic and nothing in this process involves the marketprice of risk. VI. t) = K2+ V(xO(t). See Constantinides and Richard (1978) for the derivation of these conditions. It can be shown" that the boundary conditions on the function V(x. The reason for this omission is that Merton's 10.Xp(x.612 The Journal of Finance managementsystem of a firm: it generatesa streamof cash flows which are the holding cost of cash.such as Poisson or Pareto-Levyprocesses. penalty cost of negativecash balancesand transactions costs in transferring cash in and out of interestbearing bonds. t). See Constantinides (1976)for a reviewof cash management models. other things equal. The firm controls this project.t) of the demand for cash by Step two: Evaluatethe streamof costs as if the marketprice of risk were zero. t) be the marketvalue of all futurecosts incurredin the operationof the system. t) = Vt (xo(t). CONCLUDING REMARKS It*(x.

The rate of returnon the +8)project is ( V(x(t)+ z.Market Risk Adjustmentin Project Valuation 613 intertemporal CAPM (1) is derivedunder the assumptionthat the rate of returnis CAPM generatedby a diffusionprocess. as yet. In discretetime 6 is not necessarily small and the derivationof section III is not valid.~~~~ x(t) = where the distributionof zz is known. have an intertemporal for discontinuousstochasticprocesses. in principle. are satisfied. Indeed this procedurehas been outlinedby Bogue and Roll (1974). Table 1 summarizessome developments in finance through the two methodologies. CAPM werediscussed Theoretical objectionsto the applicationof the discrete-time in our section IV-C. The Modigliani-Millerarbitrage and the CAPM are two powerful financial methodologies.It must be stressed.which lead to the CAPM. (13) In section III we are justified in expanding(13) in terms of a Taylor series and deriving (3). since yt and a are in generalfunctionsof x and t. in It is helpfulto place our rule in perspective with relateddevelopments evaluated by the sequential application of the oneperiodCAPM. Mossin (1966) and others Black and Scholes (1973) Merton (1970) This paper Black and Scholes (1973) Cox and Ross (1976) .t)8. Additional difficulties in the derivation of our rule are illustrated when we attemptto duplicatethe developmentof section III in discrete time.and the marketvalue of a streamof cash flows may. We have also limited our discussionto a continuoustime frameworkand have excluded a discrete time framework. TABLE 1 IN THE ARBITRAGE APPROACHAND THE CAPMAPPROACHIN SOMEDEVELOPMENTS FINANCE Arbitrage Approach (Requires the existtence of a risk class) CAPM approach (Conditional on the assumptions which lead to the CAPM) Modigliani-Miller propositions (no tax) Option pricing Generalized project valuation: Reduction to a riskless world. Modigliani and Miller Hamada (1969). Assume that time periods are of length 8 and that the state equation is xZ(t. in a discrete time frameworka CAPM is applicableto everytime period.We do not.After all. because 8 is small (d->O in continuous time) and the stochastic incrementsz follow the stochasticprocess(2).t+ 8)- V(x(t).each however with limitations: The arbitrageapproach requires that the securitiesunder considerationbelong to the same risk class whereas the CAPM approach requiresthat the assumptions.t)+ c}/ V(x(t).that the family of diffusionprocesses(2) is quite rich.

where J(x.thus considerablysimplifyingthe valuation.and our example in section V on cash managementmay not be solved by the Cox-Ross procedureas long as a securityor portfolio does not exist which perfectlyhedges againstthe variabilityin the demandfor cash. while the Cox-Ross procedureis limited to situations where a risk class exists. if the underlyingsecurity is traded in the market. In particularthe claim may be evaluatedin a risk neutralworld. Assume that the project is controlled by u dt in time ( long as the underlyingsecurityis not tradedin the market. if a financial claim is spanned by securitieswhich are tradedin the market. t). where J(x + dx. leadingto the CAPM. The rate of return on the project is V(x + dt. t + dt). However. Since the control u is not necessarily optimal.where investors'preferencesonly play the indirect role of determining some equilibrium parameter values. Neither of the two rules dominatesthe other: Our rule is limited to situations where the CAPM is valid. The rule developedin this paper bears some similarityto the Cox-Ross rule in the sense that both rules reduce a valuation problem under market risk to a valuationproblemin a risk neutralworld.the financial claim may be evaluatedthroughthe arbitrage approach. the securityon which the option is written) belong to the same risk class. t + dt)= V(x + dx. APPENDIX Let V(x. t) J(x. t) t) 2VX+2 VXX)dt+ dw (Al) with expectedvalue per unit time'ap. For this reasonthe derivationof the option pricingequationthroughthe arbitrage argument dominatesthe derivationthroughthe CAPM. t) < V(x. t)-J(x.e. They applied an arbitrageargumentand evaluated the option in termsof the underlying security. J(x. t) be the market value of the project. Mossin (1966) and others derived the Modigliani-Miller propositionsthroughthe CAPM.t) (c+ V+ V(x. do not hold. Thus our example in section IV-B on option pricing may not be solved by the Cox-Ross procedure.and covariancewith the marketper unit time . Black and Scholes (1973) and Merton (1970) derived the option pricing differentialequation through the CAPM. t + dt) + c dt . A paralleldevelopmenthas taken place throughthe CAPM and withoutassuming the existenceof a risk class. and the option pricing differential equationis valid. t + dt). The value of the project at t + dt is J(x + dx.Cox and Ross (1976)generalized this approachand noted that. even when the assumptions. t) J(X. then the security and the option belong to the same risk class. t). the market value of the project at t is J(x. Hamada(1969). t + dt) and is optimally controlled thereafter.614 The Journal of Finance Black and Scholes (1973) observedthat over an infinitessimaltime interval an option and its underlyingsecurity(i. providedthat the underlyingsecurityis tradedin the market. if the project is optimally controlled.J(x.

Probability.:Addison-Wesley. and M. (A6) 4. Volume 81 (1973).Thus the optimalu is given by max c-rV+ V. Richard. Volume30 (December1975). Time."Admissible Uncertainty in the MultiperiodAsset Pricing Model. of with Borrowing. cr V+ V. 444 454. C." The Journalof Finance. Roll.Volume22 (1976).1978(forthcoming). WorkingPaperNo. Journalof Political 3.Volume29 (May 1974). of Financial . "Stochastic Cash Management with Fixed and Proportional Transaction Costs.Xpc)Vx+ 2 V< 0. C. 1320-1331. t) . Black. Scholes. and Default Risk. A.pp. t). t) = 0 and (A5) is satisfiedas an equality.Market Risk Adjustmentin Project Valuation aPM given by 615 ap J(x. (A3) in If the projectis in equilibrium the capital market. 6. Reading.Kx 2 Vxx)-r= =Xpc. L." University. or (A5) vx < .pp. D. 637-659. G." 7.+ (u y-Xpa) Vx+ ."The Pricingof Optionsand CorporateLiabilities. J. F. M. "CapitalBudgetingfor Risky Projectswith 'Imperfect'Marketsfor of PhysicalGoods.pp. Science. "Existence of Optimal Simple Policies for Discounted-CostInResearch. 1969. t) > 0 and the above simplifiesinto J(x t)kc+ c . pp. Cox and S. 22-77-78. "TheValuationof Optionsfor Alternative Volume3 (January/March1976). t) + + 2vx+2Vxx) -rA J(x t) or V. Baron.2 xO ?(5 If u is optimalthen V(x.rJ(x." MarketEquilibrium Restricted 2. "Firm Valuation. a Vxx]=. M.1977(revised).J( satisfies the intertemporal CAPM of equation(1).J(x."Capital (July 1972). 1251-1264. Bogue and R. and S. F. We substitute(A2) and (A3) in (1) and obtain V(X."Operations in ventoryand Cash Management Continuous Journal StochasticProcesses. 5.Mass. Constantinides.Vx J t) .K+(u-Xpa)Vx+ REFERENCES 1.t))() + ( + t) c V++ 2Vxx) (A2) and aPM PaMaVX/ J(x."TheJournal Finance. Breiman. Ross. (M) But V(x.pp. GSIA.CorporateTaxes. t) +V + J( J (x t) dt - l t) (c+ V. Management 8.+ (u . P." Economy. Economics. Volume45 Journal Business. Carnegie-Mellon ." 9. 145-179. t) -J(X. 601-613. t) .

Introduction Stochastic to Control. 17. State-Preference "A Model of OptimalFinancialLeverage.Volume24 (March1969). Litzenberger J. 911-922. and Winston. Gonzalez.Volume28. Rolfo.pp.pp. The Volume 7 (Spring1976). E. . Volume 41 (1973). Merton. M. 33-54. 867-887. E." Journal Finance.pp. of Mass. C."A Mean-Variance Synthesisof CorporateFinancialTheory.1964. 19.Volume 12 (June 1977). Kushner. "A Theoryof OptimalCapitalStructure.Cambridge.:MIT Press. S. Litzenberger. 165-179. J. 13-31."TheJournalof Finance. The of (forthcoming).pp. "An Intertemporal 16. H. (March1972). Rubinstein. 11. R. 15. H. Cootner (editor)TheRandom Character StockMarketPrices. N. "On Mean VarianceModelsof CapitalStructure and and the Absurdityof Their Predictions. 12." P. Scott. pp."TheJournal of Finance." The Journalof Finance.MarketEquilibrium."Portfolio and Analysis. Corporation Finance." Journalof Financial and Quantitative Analysis. C. Han Kim. New York: Holt.616 The Journal of Finance 10." Bell Journalof Economics. CapitalAsset PricingModel. 13. 167-182. Hamada.Volume28 (September1973). Rinehart. "A Mean-Variance Theory of Optimal Capital Structureand CorporateDebt Capacity."Warrant Pricesas Indicatorsof Expectations in and Preferences."Econometrica.pp.R. Sprenkle. A. . M.1971. 14.1970 (mimeo). R. Krausand R."A DynamicGeneralEquilibrium Modelof the Asset Marketand Its Applications to the Pricingof the CapitalStructure the Firm."Massachusetts of Instituteof Technology. 18.

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