Investment Decisions in Uncertainty

The aim of this chapter is to take risk into account in investment decisions. Up to now, we have assumed that all calculation elements are known with certainty, both when applying the static and dynamic investment calculation methods in Chaps. 2 and 3, and when making investment programme decisions in Chap. 4 and investment duration decisions in Chap. 5. This is, of course, only true in very rare cases. For example, if we consider a savings bond with a fixed interest rate as a form of financial investment and hold it for the entire term, then from a practical point of view all calculation elements are known with certainty for the entire term. Some theoretical concerns about this view should be ignored here. If, in the context of a comparison of alternatives, this financial investment is to be compared with an operational investment, in which, for example, a new branch of industry is to be established in the company, it usually makes no sense to compare the two classically determined net present values considering fictitious investment and the removal of the reinvestment premise. The probability that the data of the planned operational investment will occur exactly as planned is much lower. Even if the investment data were planned very elaborately and are based on industry information and experts, the residual value of a production facility is, for example, much more difficult to determine than the repayment amount of a fixed-rate savings bond. This was already indicated in Sect. 1.9. In the case of two equal net present values or other target values of the dynamic investment calculation methods, the rational investment decision of a cautious businessman would certainly be to invest in the safe savings certificate instead of the investment alternative with the same net present value, which, however, would be more likely to deviate from the planned value. But what should the rational investment decision be if the net present value of the safer investment is less than the net present value of the more uncertain alternative? This chapter deals with the rational decision of the investor in such a situation. There are generally two approaches to taking risk into account in investment calculations. The theoretically better approach is to consider the risk–benefit of an investment decision. Here, the investor must specify a risk–benefit function or, if the probability of occurrence of the environmental situation is unknown, the investor uses the so-called ad hoc decision rules as defined decision routines. This procedure of determining the risk–benefit is quite complex and, theoretically, requires a high degree of abstraction. Furthermore, risk–benefit functions of investors are not intertemporally stable, i.e. the investor’s attitude at the beginning of the investment does not have to be valid at the end of the investment anymore. We will deal with these techniques in Sects. 6.5–6.8 in this chapter. As an alternative to this procedure, there are the correction procedures and sensitivity analyses, which change the data set of the considered investment object in order to determine the effects on the target values of the investment calculation. These procedures are, theoretically, not very complex and are also strongly criticised in the academic investment theory, but in practice, they are widely used and they are also a good hand to structure decision problems of investment calculation under uncertainty. These techniques are discussed in Sects. 6.3–6.4 in this chapter. The consideration of risk is always an important issue for an investor. This will become even more important in the future due to corporate financing reasons. The consideration of risk is particularly important for German companies, as they generally have considerably less equity capital than their international competitors. The regulations of Basel II and III, which aim to achieve an international competition equality of banks, determine how much liable and limited equity capital a credit institution must back for a transaction. Previously, for Basel I, this was a uniform 8%, but today it varies according to the risk of the individual transaction. The riskier a transaction is for a credit institution, the more it must be backed by equity capital, which is then not available for other profitable activities. A debtor or credit-seeking company should, therefore, always give its creditor or credit institution the opportunity to be classified as safe as possible. To this end, credit institutions generally use ratings to assess the creditworthiness of their debtors. This assessment also includes risk analyses that the debtor carries out in his company. This makes the risk analysis of investments with the current regulations of Basel II and III even more important for companies. In order to achieve these goals, it is necessary to follow the offered exercise calculations independently with the pocket calculator or spreadsheet. Enjoy your work!