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Risk, no matter how slight, is an element of virtually every capital budgeting decision. Numerous decision procedures have been proposed in the literature and reported in surveys of practitioners for dealing with risk. However, the relative performance of these decision procedures in attaining the decision maker's financial objective while also dealing with risk effectively in long sequences of capital rationing decisions is not clear. There is a need, therefore, for studies to evaluate the relative, long-term performance of common capital budgeting decision procedures used in practice and proposed in the literature for dealing with risk.
This paper reports the results of one such study [1]. The study used Monte Carlo computer simulation of long sequences of capital rationing decisions to evaluate the relative effects on the capital growth rate and risk of ruin of simulated firms each using one of six capital budgeting decision procedures for dealing with risk. The six decision procedures were:
1) RNPV/r sub a , Rank on Net Present Value (NPV) with risk-adjusted discount rate r sub a , 2) RIRR/r sub a, Rank on Internal Rate of Return (IRR) with risk-adjusted discount rate r sub a ,
3) ROPP/n sub a . Rank on Payback Period with risk-adjusted payback period n sub a ,
4) RNPV/n sub a , Rank on NPV with risk-free discount rate r as the primary criterion, and Payback Period with risk-adjusted payback period n sub a , as the secondary criterion,
5) RNPV/beta, Rank on (expected value) NPV with risk-free discount rate r as the primary criterion, and profitability risk restriction Pr[NPV < 0 <= beta ] as the secondary criterion, and
6) Random Selection.
The first five of these decision procedures use common measures of worth, IRR, NPV, or Payback Period, as the measure of economic merit, and similarly, they also exhibit some common approaches for dealing with risk. Four of them, RIRR/r sub a , RNPV/r sub a , ROPP/n sub a and RNPV/n sub a , assess risk subjectively by using either a risk-adjusted discount rate or a risk-adjusted cutoff payback period for dealing with risky investment opportunities, and the fifth, RNPV/beta, uses an opportunity's NPV probability distribution to assess an opportunity's risk more objectively. The sixth decision procedure, Random Selection, was...