Title: Project Valuation in Mixed Asset Portfolio Selection>/TD>
Authors: Janne Gustafsson
Cheyne Capital Management Limited
Stornoway House, 13 Cleveland Row, London SW1A 1DH, U.K.

Bert De Reyck
London Business School
Regent's Park, London NW1 4SA, U.K.

Zeger Degraeve
London Business School
Regent's Park, London NW1 4SA, U.K.

Ahti A. Salo
Systems Analysis Laboratory
Helsinki University of Technology
P.O. Box 1100, FIN-02015 HUT, Finland
Date: June, 2005
Status: Systems Analysis Laboratory Research Reports E16 June 2005

We examine the valuation of projects in a setting where an investor, such as a private firm, can invest in a portfolio of projects as well as in securities in financial markets. In project valuation, it is important to consider all alternative investments opportunities, such as other projects and financial instruments, because each imposes an opportunity cost on the project under consideration. Therefore, conventional methods based on decision analysis may lead to biased estimates of project values, because they typically consider projects in isolation from other investment opportunities. On the other hand, options pricing analysis, which does consider financial investment opportunities, assumes that a projectís cash flows can be replicated using financial assets, which may be difficult in practice. The main contribution of this paper is the development of a procedure for project valuation in a setting where the firm can invest in a portfolio of projects and securities, but where exact replication of project cash flows is not necessarily possible. We consider both single-period and multi-period models, and show that the valuation procedure exhibits several important analytical properties. We also investigate the pricing behavior of mean-variance investors through a set of numerical experiments.

Keywords: finance, capital rationing, portfolio selection, decision analysis, decision analysis, mixed integer programming.