The Investment Decision: Estimation Risk and Risk Adjusted Discount Rates

Abstract

i All capital budgeting decisions are made in an environment with estimation risk (or parameter uncertainty), simply because the correct project cash flows and risk adjusted discount rate (RADR) are unknown to the decision maker. The textbook literature is, however, largely silent on the subject of estimation risk in the RADR. Further, empirical studies of capital budgeting practices provide no hard evidence about how managers' decisions take into account estimation risk in the RADR. Here the impact of estimation risk in the RADR on estimates of project present values is examined. Two methods are presented for dealing with estimation risk in the RADR. The empirical survey literature provides only inferential evidence on how managers respond to estimation risk in the RADR. For example, it is known that most firms use discounted cash flow techniques and risk adjusted discount rates, sometimes in tandem with other evaluation methods such as payback (see Hodder [10] for a recent summary of the survey evidence). But it is not known if, or how, managers use these tools to account for estimation risk. Before making decisions, managers scale down estimates to compensate for perceived biases (Pruitt and Gitman [16] and Statman and Tyebjee [20]), but is this behavior an adjustment for estimation risk related bias or for other sources of bias

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