Handbook of the Economics of Finance

This chapter is concerned with the classical applied problem of capital allocation by a corporation whose securities are traded in competitive and frictionless markets. Under reasonable assumptions that are discussed, this amounts to choosing projects whose market value exceeds their cost, so that the problem becomes one of valuing uncertain future cash flows. Valuation by discounting at a risk-adjusted discount rate is shown to be admissible under certain assumptions, and the practical problems of estimating risk premia are discussed. More general valuation approaches are introduced under the rubric of certainty equivalent pricing, which is based on the martingale pricing theory of Harrison and Pliska (1981), which allows, for example, for stochastic interest rates and risk premia. This leads naturally to a discussion of real options and of the role of competition and strategic considerations in investment policy.