The Development of a Corporate Risk Policy for Capital Investment Decisions

Abstract

A corporate utility function plays a key role in the application of decision theory. This paper describes how such a utility function was evolved as a risk policy for capital investment decisions. First, 36 corporate executives were interviewed and their risk attitudes were quantified. From the responses of the interviewees, a mathematical function was developed that could reflect each interviewee's attitude. The fit of the function was tested by checking the reaction of the interviewees to adjusted responses. The functional form that led the interviewees to prefer the adjusted responses to their initial responses was finally accepted. The mathematical form of the function was considered a flexible pattern for a risk policy. The assumption was made that the corporate risk policy would be of this pattern. With the pattern for a risk policy set, it was possible to simplify the method of deriving a particular individual's risk attitude. Using the simplified method, the corporate policy makers were interviewed once more. The results from these interviews were then used as a starting point in two negotiation sessions. As a result of these negotiation sessions, the policy makers agreed on a risk policy for trial purposes. They also agreed to develop a number of major projects using the concepts of risk analysis and the certainty equivalent.

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