Title: Project Valuation under Ambiguity>/TD>
Authors: Janne Gustafsson
Cheyne Capital Management Limited
Stornoway House, 13 Cleveland Row, London SW1A 1DH, 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 E17 June 2005

This paper examines the valuation of risky projects in a setting where the investor’s probability estimates for future states of nature are ambiguous and where he or she can invest both in a portfolio of projects and securities in financial markets. This setting is relevant to investors who allocate resources to industrial research and development projects or make venture capital investments whose success probabilities may be hard to estimate. Here, we employ the Choquet-Expected Utility (CEU) model to capture the ambiguity in probability estimates and the investor’s attitude towards ambiguity. Projects are valued using breakeven selling and buying prices, which are obtained by solving several mixed asset portfolio selection (MAPS) models. Specifically, we formulate the MAPS model for CEU investors, and show that a project’s breakeven prices for (i) investors exhibiting constant absolute risk aversion and for (ii) investors using Wald’s maximin criterion can be obtained by solving two MAPS problems. We also show that breakeven prices are consistent with options pricing analysis when the investor is a non-expected utility maximizer. The valuation procedure is demonstrated through numerical experiments.

Keywords: project valuation, capital budgeting, portfolio selection, ambiguity, mathematical programming, decision analysis