|To the extent that diminishing marginal utility leads directly to risk aversion, then this risk aversion can be reflected in the basic valuation model used to determine the worth of a firm. If a managerial decision affects the firm’s risk level, the value of the firm is affected. Two primary methods are used to adjust the basic valuation model to account for decision making under conditions of uncertainty.|
Utility and Risk Aversion in Investment Decision
The assumption of risk aversion is basic to many decision models in managerial economics. Because this assumption is too crucial, it is appropriate to examine attitudes toward risk and discuss why risk aversion might hold in general.
1. Possible risk attitudes
In theory, three possible attitudes towards risk are presents aversion to risk, indifference to risk, and preference for risk. Risk aversion characteristics individuals who seek to avoid or minimize risk. Risk neutrality characteristics decision makers focus on expected returns and disregard the dispersion returns (risk). Risk seeking characteristics decision makers prefer risk. Given a choice between more risky and less risky investments with identical expected monetary returns, a risk averter selected the less risky investment and a risk seeker selected the riskier investment. Faced with the same choice, the risk-neutral investor is indifferent between the two investment projects.
Given the importance of attitudes towards risk in economic decision making it is important to ask what factors are involved in the determination of such attitudes. Managerial economics tends to presume that the majority of economic participants are risk averters, and it makes this presumption on the basis of the principle of diminishing marginal utility of money.
2. Relation between money and its utility
At the heart of risk aversion is the notion of diminishing marginal utility for money. If someone with no money receives $5,000, it can satisfy his or her most immediate needs. If such a person then receives a second $5,000, it will obviously be useful, but the second $5,000 is not quite so necessary at the first $5,000. Thus, the value or utility of the second or marginal $5,000 is less than the utility of the first $5,000 and so on. Consequently, diminishing marginal utility of money implies that the marginal utility of money income or wealth diminishes for additional increments of money.
Now, if this principle holds generally then it has an important implication for attitudes towards a 50/50 risk of gaining or losing a given monetary amount. This is that the extra benefit from making an equally likely gain is less than the loss of benefit from enduring an equality likely loss. For this reason, the diminishing marginal utility of money tends to make for risk aversion.
3. Adjusting the valuation model for risk
Under conditions of risk, the profits shown in the numerator of the valuation model as π equal the expected value of profits during each future period. This expected value is the best available estimate of the amount to be earned during any given period. However, since profits cannot be predicted with absolute precision, some variability is to be anticipated. If the firm must choose between two alternative methods of operation, one with high expected profits and high risk and high risk and another with smaller expected profits and lower risks, some technique must be available for making the alternative investments comparable. An appropriate ranking and selection of projects is possible only if each respective investment project can be adjusted for considerations of both time value of money and risk.
4. Certainty equivalent adjustment
The certainty equivalent method is an adjustment to the numerator of the basic valuation model to account for risk. Under the certainty equivalent approach, decision makers specify the certain sum that they comparable to be expected value of a risky investment alternative. The certainty equivalent of an expected risk amount typically differs in monetary terms but not in terms of the amount of utility provided.
5. Risk-adjusted discounts rates
Another way to incorporate risk in managerial decision making is to adjust the discount rate of denominator of the basic valuation model equation (iii). Like certainty equivalent factors, risk-adjusted discount rates are based on the trade off between risk and return for individual investors.