Project valuation under incomplete capital

markets: The case of non- diversified

entrepreneurs

Darcy Fuenzalida* Samuel Mongrut** Mauricio Nash*

* Department of Industries
Universidad Tcnica Federico Santa Mara

** Department of Accounting
Universidad del Pacfico

___________________________________________________________________

Abstract

Traditional risk analysis usually ends up with the probability distribution of the project
net present value (NPV). However, this probability distribution is it difficult to interpret
because the project risk vanishes as uncertainty related to its critical variables
disappear, which happens gradually as time goes by. In other words, it is unlikely that
project risk will be resolved between today and tomorrow as suggested by the
probability distribution of the project NPV. In contrast with this traditional output, in
this work one uses risk analysis to estimate the project stand-alone risk for each
future period along the project explicit forecast horizon. This methodology stresses
the importance of the entrepreneurs perspective in assessing the project risk and the
use of sensitivity and simulation analyses. The goal is to estimate a commensurate
risk-adjusted hurdle rate for each period whenever there are no tradable benchmarks
and investors do not hold a well-diversified portfolio of investments. Finally, a clear
cut investment rule can be applied.

JEL Classification: H43

Keywords: Project valuation, hurdle rate, risk analysis

___________________________________________________________________

Corresponding authors: Mauricio Nash, Universidad Tcnica Federico Santa Mara,

Departamento de Industrias, Las Nieves 3435, Departamento 116, Vitacura, Santiago de
Chile. Email address: mauricio.nash@usm.cl
 2

1. Introduction
Project valuation remains as one of the most important tasks that any financial
manager must accomplish (Hertz [15], [16], and [17]). The importance of such task
has been recognized long ago in the literature, but the proposals about the way in
which it may be conducted have varied across the years. Figure 1 illustrates a
possible classification of the different proposals based on two possible perspectives
that managers can take when assessing the project value: the short cut perspective
and the customary perspective.

Under the short cut perspective, managers put an emphasis in the market
view about the project risk. In this sense, managers avoid the direct assessment of
the project risk by using a tradable benchmark, which is assumed to be the twin
security of the project value1. The short cut perspective could be divided further into
the risk-adjusted (RA) method and the certainty-equivalent (CE) method2. In the
former case one discounts the project risky cash flows at the risk-adjusted hurdle rate
estimated through an equilibrium model, while in the later case one discounts the
project riskless cash flows at the risk free rate (Myers and Robichek [33])3.

From the figure one may see that both methods could be implemented using
two different approaches: the Discounted Cash Flow (DCF) approach and the Real
Option (RO) approach. Under the DCF approach managers use the historical market
beta of a similar single-project firm (SSPF) as a proxy for the project market risk4. In
principle, this approach could be applied under both methods because the CE
method is just the counterpart of the RA method5. However, it is difficult to apply the
DCF approach under the CE method because the riskiness of the project cash flows
also depend on the variability of cash flows during the previous period, so it is difficult
to estimate the project risk premium for each period without a direct assessment of
the project risk (Hodder and Riggs [18])6. Perhaps due to this limitation, the
application of the DCF approach under the RA method has gained more popularity
among practitioners than its application under the CE method.

Recently, the Real Option (RO) approach has emerged as an alternative way
of implementing the CE method. Under this approach managers use a non-arbitrage
condition to obtain risk-neutral probabilities, which in turn are used to estimate the
project riskless payoffs or certainty-equivalent cash flows (Trigeorgis [47]). In this
way, certainty-equivalent cash flows are obtained by multiplying risky cash flows with
risk-neutral probabilities and not through the estimation of the project risk premium.

1
Hence, the project value and its twin security will have the same market risk.
2
There is third method called the Single Certainty Equivalent (SCE) where one discounts risky
cash flows at the risk-free rate and the result is multiplied with a certainty-equivalence factor
(Chen and Moore [5]). Keeley and Westerfield [22] have shown that the SCE method yields
quite large errors, so managers are better off with the RA method or the CE method.
3
Usually the equilibrium model is the Capital Asset Pricing Model (CAPM).
4
The identification of SSPF is usually restricted to identify firm(s) in the same line of business,
but this task, when properly applied, is far more complicated (see Myers and Turnbull [34]).
5
Nonetheless, the CE method is theoretically superior to the RA method because it treats
separately the time value of money from the project risk (see Myers and Robichek [33]).
6
The project risk premium is then subtracted from the project risky cash flows to obtain the
certainty-equivalent cash flows, which can be discounted at the risk-free rate. The use of the
project risk premium has been criticized because it is subjective and does not yield a project
value from the investors (market) point of view (Brigham and Gapenski [4]).
 3

Figure 1: Proposals for Project Valuation7

PROJECT
VALUATION

SHORT CUT
CUSTOMARY
PERSPECTIVE
PERSPECTIVE

EMPHASIS IN THE
INVESTOR'S VIEW EMPHASIS IN
THE MANAGER'S
VIEW

SUITABLE FOR
COMPLETE CAPITAL
MARKETS DIRECT
ASSESSMENT OF
PROJECT RISK

RISK-ADJUSTED (RA) CERTAINTY-EQUIVALENT

METHOD (CE) METHOD IN PRINCIPLE
SUITABLE FOR
INCOMPLETE
CAPITAL
DCF APPROACH DCF APPROACH RO APPROACH (WITH MARKETS
(WITHOUT MANAGERIAL (WITHOUT MANAGERIAL MANAGERIAL
FLEXIBILITY) FLEXIBILITY) FLEXIBILITY)

SENSITIVITY SIMULATION
DECISION TREES
THE PROJECT RISK IS CE CASH FLOWS ANALYSIS ANALYSIS
CE CASH FLOWS
ASSESSED DIRECTLY BY OBTAINED USING AN
OBTAINED USING AN
USING AN EQUILIBRIUM ARBITRAGE
EQUILIBRIUM MODEL
MODEL ARGUMENT
PROBABILITY
DISTRIBUTION
OF THE NPV
DECISION RULE: DECISION RULE: STATIC DECISION RULE:
STATIC NPV NPV STRATEGIC NPV

IN ANY CASE ONE MUST FIND A

TRADABLE BENCHMARK THAT
REPLICATES THE PROJECT RISK

Under the short cut perspective one uses the Net Present Value (NPV) as a
decision rule. However, under the DCF approach one uses the static NPV, while
under the RO approach one uses the strategic NPV. The word static means that the
traditional NPV is unable to capture the asymmetry in the project payoffs, which is
caused by the presence of embedded managerial flexibility or real options. In this
sense, the static NPV implicitly assumes that the project operating strategy is defined
from the outset and that it will not be changed until the end of the project useful life,
so it is a now or never proposition.

Under the RO approach it is possible to expand the static NPV in such a way
that it incorporates the embedded managerial flexibility. This expanded NPV rule is
called strategic NPV, which is just the sum of the static NPV and the real option
premium (Trigeorgis [47]).

The customary perspective aims to assess directly the project risk by using the
information of managers, entrepreneurs, and experts about the investment proposal.
In this sense, it puts more emphasis in the entrepreneurs experience and knowledge
about the project. In performing this task several tools are used such as sensitivity
analysis, simulation analysis, and decision tree analysis (Myers [32]). Originally, it
was introduced as a substitute of the short cut perspective, with two major
shortcomings: its fragmentary view and the lack of a clear-cut decision rule (Mongrut
[31]).
7
Otherwise stated, all figures and tables are own elaboration.
 4

Fragmentary view means that the different tools were viewed as being
mutually exclusive instead of complementary. Notwithstanding, there have been
some attempts towards the integration of the different tools. Two attempts are
noteworthy: the risk analysis procedure given by Hertz [15] and the one given by
Myers [32]. In the Hertzs procedure sensitivity analysis was used to determine the
project critical variables. Then, these variables were characterized using probability
distributions with the aim of performing a simulation to obtain the probability
distribution of the project returns and the probability distribution of the project NPV.
Nevertheless, a link between the project risk analysis and the estimation of the
project risk-adjusted hurdle rate was not yet established.

The Myers procedure was very much in line with Hertzs proposal. However,
he went further in suggesting that simulation analysis can be used repeatedly to find
out the risk of a typical project and its corresponding risk-adjusted hurdle rate.
Unfortunately, his proposal did not include a link between project risk analysis and
hurdle rates beyond the average-risk case8. In this respect, Trigeorgis [47] contends
that a more proper use of simulation analysis would be as an aid to obtain the proper
project risk-adjusted hurdle rate and, in this way, apply the NPV as investment
criterion. This idea is important because it suggests a general link between the
project risk analysis, the estimation of the project risk-adjusted hurdle rate and the
use of the NPV as a clear-cut decision rule.

The other shortcoming of the customary perspective is the lack of a clear-cut

decision rule. From figure 1, one may see that the usual result of the project risk
analysis is a probability distribution of the project NPV. Myers [32] has pointed out
that the meaning of such distribution is unclear because all the uncertainty about the
project cash flows is not going to be resolved between today and tomorrow, which is
precisely what this distribution suggests.

It is possible to argue that the customary perspective is a complement of the

short cut perspective when managers cannot find or use suitable tradable
benchmarks to span the project risk (incomplete capital markets)9. Besides, the
different tools for assessing the project risk may also be regarded as complementary,
as part of an integral process. Precisely, the proposed methodology under
incomplete capital markets involves the use of different tools to assess the project
risk and from it to estimate a project hurdle rate or required return for each period
along the investment horizon. Then, a clear-cut investment rule such as the Net
Present Value (NPV) can be estimated.

Nevertheless, one may wonder how such project hurdle rates may be
estimated? In this work, one assumes that investors are the least risk-averse
entrepreneurs willing to put all their capital in one project, so they do not hold well-
diversified investment portfolios and the Capital Asset Pricing Model (CAPM) cannot
be used to estimate the project market value.

8
Bower and Lessard [2] also rely on the managers knowledge in the project to determine the
appropriate hurdle rate of the average-risk project.
9
It is clear that managers will not find a tradable benchmark in the case of projects in a new line
of business. However, it could also be the case that the tradable benchmark exists, but it is no
applicable because it is biased (it includes effects not applicable to the project like growth
options) or because investors face restrictions to traded with the financial assets (technically
incomplete capital markets).
 5

Instead of estimating the project market value, non-diversified entrepreneurs

must estimate the investment project based on the project total risk. Hence the
resulting project expected added value is subjective in nature and the best one may
do in incomplete markets is to provide an unbiased lower value for the project hurdle
rate, which implies an upper value for the project added value.

Well-diversified investors may also estimate the project cost of equity capital
in incomplete capital markets. However, for them some questions must be answered
previously: Can one use the CAPM in a multi-period setting? If capital markets are
inefficient, can one still rely on the CAPM for capital budgeting purposes? Are
estimation errors in project cash betas likely to induce serious errors in the estimation
of the project risk-adjusted hurdle rates? Are we subject to systematic bias when
using cash betas?10

Recently, Hearings and Kluber [14] have shown that the CAPM provides a
good benchmark for pricing assets under incomplete markets even in the case when
investors are not mean-variance optimizers and assets returns are not normally
distributed. The reason for this finding is that pricing errors are extremely small.

Fama [8] favors the use of the CAPM in a multi-period setting if discount rates
and market variables (such as the risk-free rate, and risk premium) evolve in a
deterministic fashion from one period to another11. In this sense, our knowledge
about the project risk must be deterministic, but not our knowledge about the project
cash flows.

Stein [45] argues that what is crucial to the use of beta as a capital budgeting
tool is the managerial time horizon and whether the firm faces or not financial
constraints. Whenever managers have a long-term horizon what really counts is the
measure of the project fundamental risk and in this case it doesnt matter whether
beta does or not a good job in explaining the cross-sectional differences in stock
returns because paying attention to this would imply a short-term investment horizon.
If the firm is financially unconstrained, managers will not wish to engage in short-run
market operations (e.g. stock repurchases) to take advantage of market inefficiencies
(e.g. to raise the firms share price), so again one could take a long-term investment
horizon and use the CAPM as capital budgeting tool.

Due to the fact that the proposed methodology can also make use of cash
betas, one may wonder whether errors in the estimation of cash betas have an
important impact in the estimation error in risk-adjusted hurdle rates. Ferson and
Locke [10] have shown that most part of the error in estimating the market cost of
equity capital is found in the risk premium estimate and not in the measure of market
betas12. It is possible to show that the same result holds if managers use cash betas
as proxies of market betas13.
10
Here one presents a plausible answer to these questions given by the academic literature.
Certainly, some of these questions are still subject to ongoing research.
11
This issue is important because the estimation of risk-adjusted cost of equity capital will
depend on the cash flows variability, so one may find different cost of equity capital along the
project horizon.
12
The variance of the error in the estimation of risk (beta) accounts only for 7% or less of the
total variance of the error.
13
This observation could be obtained by including the specification of Schachter and Butler [43]
into the framework of Ferson and Locke [10].
 6

Schachter and Butler [43] have shown that whenever one uses cash betas
instead of market betas, the estimation risk in risk-adjusted cost of equity capital
depends exclusively on the estimation risk in the project cash flows. In this situation,
there could be no bias or, if there is bias, its direction could be upward or downward,
so it is not systematic.

This research aims to answer the following question: How managers can
apply the customary perspective to valuate real investment proposals under
incomplete capital markets without managerial flexibility? This research question
could be divided into the following questions: what is the process to conduct a proper
project risk analysis? How managers and experts information is obtained and use it?
How can one establish a connection between the project risk analysis and the
estimation of the project hurdle rate? In what cases the dimensions of project risk
matters? How it is possible to estimate the project discount rate in these cases?

In order to keep the explanation as simple as possible, the proposed

methodology is introduced without managerial flexibility or real options, and within the
surprise-free or business-as-usual scenario. This choice implies that it is enough to
use sensitivity and simulation analyses for risk analysis purposes and the static NPV
as investment rule. Furthermore, the methodology is presented in discrete time
because it is more intuitive for managers and entrepreneurs. Additionally, a number
of assumptions have been made: firms are not financially constrained and they do
not practice capital rationing, projects are independent, there are no personal taxes,
and there is one risk-free rate.

The remainder part of the research has been organized as follows: the next
section discusses the three dimensions of project risk: the project stand-alone risk,
the project contribution to the sponsoring firms within-the-firm risk, and the project
contribution to the sponsoring firms market risk14. An overview of the entire
methodology is given in the third section, while the next four sections explain more in
detail each part of the proposed methodology. In section 8, one discusses the
limitations of the proposed methodology and future lines of research. Section 9
concludes the work.

2. Dimensions of project risk

Figure 2 shows the three dimensions of project risk: the stand-alone risk, the
within-the-firm risk and the market risk. The project stand-alone risk sees the project
risk in isolation, which means without taking into account diversification effects. This
risk is relevant for non-diversified entrepreneurs. The other two types of project risk
consider the diversification effects. The project within-the-firm risk is the project
contribution to the overall risk of the firm, so it is important to find out what is the
impact of taking on a project in the total risk of the sponsoring firm15. The project
market risk is the project contribution to the risk of a well-diversified investors
portfolio. It would be the project market beta if the project were to be traded in the
capital market.
14
In this research the following names are interchangeable: total risk, stand-alone risk,
fundamental risk, business risk, and operating risk.
15
This is a way to recognize that the sponsoring firm holds a portfolio of projects. This situation
is relevant for non-well diversified investors, and also for non-diversified entrepreneurs
whenever they start to invest in a different line of business.
 7

For corporate managers, it could be beneficial to undertake projects that

diversify further the firms portfolio of projects to prevent substantial cash flows and
earnings swings that could cause financial distress, to reduce the cost of debt, to
provide greater borrowing capacity, to guarantee availability of raw materials and so
on (Megginson [29])16. Nevertheless, there also could be opposing forces to the
within-the-firm corporate diversification. There is evidence that diversified firms invest
too much in segments with poor investment opportunities and this situation destroys
the market value of the firm (Lamont and Polk [24])17.

Although it could be that within-the-firm corporate diversification and the firm

value are negatively correlated, there is evidence that managers do not always
behave in a way that maximizes the market value of the firm. Indeed, managers
could undertake investment projects for different reasons (e.g. to avoid the risk of
insolvency, etc) and they could also suffer from agency problems.

Figure 2: Dimensions of Project Risk

DIMENSIONS OF
PROJECT RISK

PROJECT
STAND-ALONE
RISK (SAR)

ROICP
PROJECT PROJECT
CONTRIBUTION CONTRIBUTION
TO THE WITHIN- TO THE FIRM'S
THE-FIRM RISK MARKET RISK

ROICP ROICP
WF = M=


. ROIC ,


. ROIC ,ROIC 

ROICSFo P SFo


RM P RM

Source: Adapted from Brigham and Gapenski [4]

Figure 2 also shows how one could measure each dimension of project risk.
The stand-alone risk is estimated by using the standard deviation of the project
returns on invested capital (ROIC), where the return on invested capital is defined as
follows18:
16
In the case of corporate firms, managers are concerned with a potential risk of financial
distress when they face a large and risky project (Mao [28]). In such a case, managers could
undertake small diversification projects to avoid such a risk and in this way preserving the
firms earnings power.
17
This is precisely the hypothesis of the inefficient internal capital market. However, the desire of
managers to avoid the risk of financial distress could be a partial explanation for
overinvestment in poor segments.
18
Copeland, Koller and Murrin [7] provide a equivalent expression. This formula implies that
managers and entrepreneurs conduct a detailed financial planning of the project. Due to the
fact that outside investors care about the stability of earnings per share, Lerner and Rappaport
[25] have suggested that it is desirable for managers to conduct a detailed financial planning
of the project because it allows them to see the impact of taking on the project in the firms
expected cash flows and earnings (see also Sloan [44]).
 8

EBITt (1 T ) FCFt
ROICt = ... (1)
(ICt )(RRt )
Where:

CEt Dept + NWK t

ICt =NWK t +FA t + (NCA t -NCL t,wi ) RR t =
EBITt (1 T )

FCFt : Free cash flow

EBITt : Earnings before interests and taxes
ICt : Invested capital
T: Tax rate
RR t : Retention ratio
NWK t : Net working capital
FA t : Fixed assets
NCA t : Non current assets
NCL t,wi : Non current liabilities no subject to interest
CE t : Capital expenditures
Dept : Depreciation

It is important to note that all dimensions of project risk must be measured in a

forward-looking way. Note that the project within-the-firm beta ( WF ) and the project
market beta ( M ) depend on the project total risk ( ROICP ), and this is usually
estimated using simulation analysis, which is a forward-looking technique.

Traditionally, the project contribution to the within-the-firm risk and to the

market risk have been treated without interconnection. However, there is evidence
that well-diversified investors could also care for the within-the-firm diversification.
One could argue that corporate or diffusely held firms may face two situations in
which the within-the-firm diversification must be considered by well-diversified
shareholders: in the case of large and risky projects and in the case of project
interdependency (Trigeorgis [47]) In these situations the within-the-firm diversification
and the market diversification must be connected to each other.

In the case of a closely held firm the link between both dimensions of project
risk must be made when the project is large and risky and when it offers
diversification effects to the owner of the firm (Pettit and Singer [39]). In both cases,
whenever a large and risky project is financed with debt it will increase the firms risk
of financial distress, so the unlevered project beta must be adjusted upwards to
reflect the higher project financial risk19.
19
If the project is financed with debt its total risk will increase because the project needs to
generate the enough cash flow to repay the debt and offer economic gains, so the project
unlevered cash beta will increase through an increase in the firms total risk including the
project and it will no longer reflect only business risk. In this research it is assumed that the
firms debt level remains within a range in which the firms business risk including the project is
not affected by an increment in debt due to project financing.
 9

3. Methodology under incomplete capital markets

Figure 3 depicts an overview of the proposed methodology. The process starts
with the elaboration of the financial model that includes the projection of the variables
in the base case. This could be done according to the managers experience and
expectations. These initial values will be changed afterwards according to the
experts knowledge and experience.

The next phase consists in the estimation of the project stand-alone risk. This
is the most important phase because here managers identify and characterize the
project critical variables, conduct a simulation analysis and estimate the project total
risk using different measures. The characterization of critical variables remains as the
most important step because this task is performed using managers, entrepreneurs,
and experts knowledge and expectations.

The third phase of the process aims to estimate the project cash betas when
all dimensions of project risk are important and when the within-the-firm risk is not
relevant. These cases belong to non-well diversified investors and well-diversified
investors, respectively. In these situations, it is necessary to estimate the expected
market returns and variability to estimate the project unlevered cash betas. In the
case of non-diversified entrepreneurs, it is not necessary to apply this phase since
the project stand-alone risk is a enough input to estimate the project risk-adjusted
hurdle rate.

The fourth phase consists in the estimation of the project risk-adjusted

discount rate, which may be a cost of equity capital or a hurdle rate depending on the
investors degree of diversification. In any case, one needs to check three
consistencies: the consistency with the project financial structure, with the project
fundamental risk, and with the projection of prices. The consistency with the project
financial structure enters twice in the analysis: to select the appropriate expression to
estimate the project risk-adjusted cost of equity capital and to estimate the project
added value. There are two main strategies that managers could follow concerning
the project financial structure: to target the monetary unit level of debt outstanding
over time or to target a constant debt to value ratio. In the case of non-diversified
investors one must use the first strategy because the project hurdle rate is not a cost
of capital.

Under the strategy that targets to monetary unit level of debt outstanding,
managers commit to a temporary or permanent predetermined schedule for the
absolute amount of debt to be used (Inselbag and Kaufold [21]), while under the
strategy that targets a constant debt to value ratio managers do not predetermine the
future amount of debt, so tax shields are uncertain. Nevertheless, under the later
strategy, it is also possible to have the first tax shield certain when is based on the
current level of debt (Taggart [46]). Depending on the project strategy with respect to
its financial structure managers may choose an expression to estimate the project
risk-adjusted hurdle rate according to the Adjusted Present Value (APV) method or
the Weighted Average Cost of Capital (WACC) method. Under the APV method they
must estimate unlevered risk-adjusted hurdle rate or cost of equity capital using the
project unlevered cash betas in the later case, while under the WACC method they
should estimate levered risk-adjusted cost of equity capital using the project levered
cash betas.
 10

Figure 3: Overview of the Methodology

ESTIMATION OF THE NPV

ASSUMPTIONS AND
(APV METHOD OR WACC METHOD
ELABORATION OF THE
FINANCIAL MODEL

Estimation of project added value

PROJECTION OF
VARIABLES IN NOMINAL
VALUES (BASE CASE)

ESTIMATION OF NOMINAL RISK-

Elaboration financial model ADJUSTED HURDLE RATES

IDENTIFICATION OF
CRITICAL VARIABLES Consistency with the projection of prices
(SENSITIVITY ANALYSIS)

CHARACTERIZATION OF
CRITICAL VARIABLES ESTIMATION OF TIME-VARYING
OR CONSTANT RISK-ADJUSTED
HURDLE RATES

SIMULATION ANALYSIS

Consistency with the project total risk

ESTIMATION OF THE
PROJECT TOTAL RISK

CHOICE OF THE FORMULA TO

ESTIMATE THE RISK-ADJUSTED
Estimation of the project total risk HURDLE RATE
(APV METHOD OR WACC METHOD)

ESTIMATION OF PROJECT
CASH BETAS
TO TARGET THE
TO TARGET A
LEVEL OF DEBT
CONSTANT DEBT TO
OUSTANDING OVER
VALUE RATIO
ALL DIMENSIONS THE WITHIN-THE- TIME
OF PROJECT RISK FIRM RISK IS NOT
ARE RELEVANT RELEVANT
MANAGERS' FINANCIAL
STRATEGY FOR THE
PROJECT
ESTIMATION OF EXPECTED
MARKET RETURNS AND
VOLATILITY Consistency with the project financial structure

Estimation of cash betas Estimation of risk-adjusted hurdle rates

In order to fulfill the consistency with the project fundamental risk it is not only
necessary to estimate the project unlevered cash beta using the project total risk, it is
also important to check whether the pattern of the project total risk is consistent with
the pattern of estimated risk-adjusted discount rates. If the project total risk increases
at a constant rate one must have a constant risk-adjusted discount rate along the
project horizon, while if it increases at a variable rate, one should have time varying
risk-adjusted discount rates20.

20
See Myers and Robichek [33], Brigham and Gapenski [4], and Mongrut [31].
 11

The consistency with the projection of prices means that if one uses current
prices in the financial planning one must use nominal risk-adjusted discount rates,
while if one uses constant prices one must use real risk-adjusted discount rates.
However, as one shall see the former procedure is better than the later21.

The last phase consists in the estimation of the project static NPV. Here one
needs to estimate the static NPV using a valuation method (either APV or WACC)
according to the project financial strategy. Non-diversified investors, must use the
APV method. Finally, it is possible to check, for well-diversified investors, the
consistency between both methods using the CAPM approach or the Modigliani-
Miller (MM) approach22.

4. Estimation of the project stand-alone risk

The objective of this section is to outline and describe the procedure that one
may follow to estimate the project stand-alone risk. According to figure 4, the process
involves four steps: identification of critical variables, characterization of critical
variables, simulation analysis and estimation of the project stand-alone risk. In what
follows one describes more in detail each step.

4.1 Identification of critical variables

An input variable is qualified as being critical in comparative terms to other

input variables that also have an influence in the output variable. By means of a
what-if analysis or sensitivity analysis one is able to discover which variables have
little impact on the output variable and which variables have a significant influence.
Those variables that have a significant influence are called critical variables.

One may state three suggestions in relation to the identification of critical

variables: it is necessary to have a model that interrelate all variables, one cannot
state beforehand which variables are going to be critical, and it is advisable to use
specialized software to identify them.

Regarding the first suggestion, it is always necessary to build a financial model

with initial values for all variables. However, what should be the level of
desegregation in the model? Unfortunately, there is no a clear-cut answer to this
question, but according to Hull [20] the level of desegregation depends on the trade-
off between more clarity for the experts judgment and less dependencies between
critical variables to deal with. Aggregate measures of the project profitability like the
NPV are not useful without a proper risk analysis.

Concerning the second suggestion, it would be not wise to point out some
variables as critical without conducting a sensitivity analysis. However, given the line
of business of the investment proposal and the managers and experts knowledge
they could suspect that some variables are more likely to be critical than others, but
this intuition only should help them to verify the results.
21
Despite what some authors contend, the consistency with respect to the projection of prices
does not mean that both procedures should give the same NPV because this would imply
inflation neutrality (see section 6.3).
22
Taggart [46] provides a review of the MM Approach and CAPM Approach to check the
consistency between the valuation methods.
 12

Nowadays, it is easier to perform a sensitivity analysis using specialized

software, like Top-Rank (Palisade Corporation [36])23. This program introduces vary
functions in each cell of the spreadsheet model without specifying a particular
probability distribution for each variable, then it varies the initial values within a range
and makes a ranking of the input variables from those who affect more the output
variable to those who have a minor influence. Of course, only the variables that have
an important influence over the output variable are considered for a further modeling
and the others are assumed constant.

This software also helps to solve some problems related to the sensitivity
analysis. Due to the different nature of the variables, one cannot vary all the variables
in the same fixed percentage (say 10%), so it is necessary to assign ranges of
variations according to the nature of each variable. Besides, some variables must
vary jointly instead of individually while holding other variables constant. For
example, it makes sense that sales price and quantity vary jointly depending on the
expected price elasticity of the product.

The software automatically changes all input variables in the spreadsheet

model, tracks all the results, and ranks them according to their impacts. It also shows
the results graphically using Spider and Tornado graphs in which one may readily
see which variables have a major influence in the output variable.

In brief, the procedure to identify critical variables could be summarized as

follows: first, one assigns a range of variation to each variable according to its nature.
Then, one identifies which variables in the model should vary jointly and allow them
to do so24. The next step is to conduct the sensitivity analysis itself. From these
results one may readily see which variables have an important influence in the output
variables25. The modeling of these critical variables is the subject of the next section.

4.2 Characterization of critical variables

Once the critical variables have been identified, one should characterize their
behaviour. Figure 4 shows a panoramic view of the process. The process starts with
the identification of dependencies among values and variables. One may have
dependency between two or more critical variables within each period or dependency
across periods for the values of the same critical variable.

Two or more critical variables are dependent within the same period if the
value of one of them influences the value of the others, for example the amount of
variable costs depends on the sales quantity. In particular, critical variables may be
dependent or independent. The critical variables that are independent represent true
sources of risk while the critical variables that are dependent represent a combined
source of risk. In the later case, one needs to find the true source of risk. If this is not
possible, one should recognize somehow their dependency26.
23
The company Palisade Decision Tools has developed the programs Top-Rank, Best-Fit, and
@Risk. These programs work as add-in for excel, so they contribute to make easier the
already difficult task of assessing the project risk.
24
The software also reports the results for joint variables through the multi-way analysis.
25
The output variables are the project FCF and the project ROIC per period.
26
One also deals with this sort of dependency when one performs the sensitivity analysis of joint
variables. If the joint effect is not important, it is not necessary to model their dependency.
 13

Figure 4: Characterization of Critical Variables

IDENTIFICATION
OF DEPENDENCIES
IN THE MODEL

ESTIMATION OF THE FIT THE SUBJECTIVE

HISTORICAL PROBABILITY
CUMULATIVE AND SUBJECTIVE
INFORMATION DISTRIBUTIONS TO
NO PROBABILITY DISTRIBUTIONS
ABOUT THE CRITICAL PARAMETRIC
USING THE "WHEEL OF
VARIABLES? DISTRIBUTIONS USING
PROBABILITIES"
THE KOLMOGOROV-
SMIRNOV GOODNESS-
OF-FIT TEST
YES
ESTIMATION OF THE
CORRELATION COEFFICIENTS

FIT THE HISTORICAL DATA

TO A PARAMETRIC
PROBABILITY
DISTRIBUTION USING THE THE SUBJECTIVE
ANDERSON-DARLING PARAMETERS OF THE
GOODNESS-OF-FIT TEST PARAMETRIC DISTRIBUTIONS
ARE THOSE THAT OPTIMIZE
THE GOODNESS-OF-FIT TEST

ASSIGN THE PARAMETRIC AGREEMENT OF THE EXPERTS

DISTRIBUTIONS AND
SUBJECTIVE PARAMETERS TO
THE CRITICAL VARIABLES AND
INSERT THE CORRELATION
COEFFICIENTS, IF NECESSARY
ABOUT THE CORRELATIONS IN
THE MODEL, THE GENERAL
SHAPE OF THE PARAMETRIC
DISTRIBUTIONS, AND THE
SUBJECTIVE PARAMETERS

The dependency between values of the same variable across periods implies
that the value for period t will depend on the value for period t-1 (first-order
autocorrelation). In this case, one also needs to recognize such dependency.
Unfortunately, most of the times one must deal with dependencies within each period
and across periods, failure to recognize these dependencies will cause a serious
problem in the simulation analysis because some combinations obtained by sampling
independently from the probability distribution of each critical variable are simply not
possible. As a result, the estimation of the project stand-alone risk will be biased.

There are three ways to deal with dependencies within each period or
between variables: to use several conditional subjective probability distributions for
the dependent variable, to include the dependencies between parameters within the
simulation analysis, or to use correlation coefficients between variables or values.

In the first case, one uses a cumulative and subjective probability distribution
for the independent variable and several conditional distributions for the dependent
variable, each of these being conditional on the independent variable lying within a
different interval. However, the huge amount of estimations that experts must give in
order to draw such conditional probability distributions makes this approach an
unpractical one.
 14

The second proposal is related to the sampling scheme during a simulation

analysis. Hull [19] gave one interesting sampling scheme to conduct the simulation
analysis. Lets assume that one has a variable X1, which is dependent of a variable
X2 and that one also has unconditional subjective probability distributions for both.
The dependency between both variables could be given by taking values of the tail
distribution of X1 as median estimates for the distribution of X2. The software
@Risk is capable of implementing the sampling scheme proposed by Hull [19] or a
sampling scheme that one believes describes better the dependency between
variables27. One could do this by assigning a parametric probability distribution to
each dependent critical variable in such a way that at least one of the parameters will
depend on the values simulated for the independent critical variable. Unfortunately,
there is no criterion to make such assignment.

The third proposal, which is suggested in this research, consists in the use of
correlation coefficients between the values of the same critical variable across
periods and among variables within each period. However, this raises the question
about how one could estimate such correlation coefficients. Hopefully, there are
correlation assessment methods such as the statistical approach, the probability of
concordance and the conditional fractile estimates28.

In the first method experts with training in statistical data analysis may see the
scatter plot of the relationship between two variables and make a close assessment
of the correlation coefficient among the variables. Under the second method
managers assess conditional probabilities or joint probabilities and relate these
estimates to a measure of dependence. In the last method, managers must assess
the Spearmans correlation coefficient using conditional information given by experts.

According to figure 4, after the identification of the model dependencies, the

next step is to find out whether there is historical information about the critical
variables. If one finds historical information about critical variables from a similar
project it could be used to determine the probability distribution that most likely fits
the data by using a goodness-of-fit test and the correlation coefficients among the
critical variables and values. In this situation, it is not necessary to use correlation
assessment methods because one may assume constant the historical coefficients.

It is important to mention that the subjective parameters are those that

optimize the goodness-of-fit and not those that belong to the input distribution. In this
case, one needs the experts opinion to assess whether historical estimates could
also be considered as expected values. If they agree, one assigns the fitted
probability distributions and the parameters obtained to each critical variable taking
into account its dependencies. If they do not agree, the process must be repeated.

Without historical information one estimates the subjective cumulative

probability distribution for each critical variable using the managers, entrepreneurs,
and the experts opinions. In this sense, it is important to state that each cumulative
probability distribution must be determined without any dependency. The
dependencies between variables and values will be inserted in the model through the
correlation coefficients.
27
For more details about the software @Risk see Palisade Corporation [37]
28
Gorkhale and Press [12] discuss the first method, while Clemen and Reilly [6] give an
overview of the three methods.
 15

A major problem in eliciting experts opinions is the possibility to get biased

estimates. A bias is a conscious or subconscious difference between the experts
opinion and an accurate description of his underlying knowledge (Hull [20]).
According to Hull [20], the bias can be classified in two types: motivational and
cognitive bias.

Motivational bias arises mainly when some of the experts are also managers
of the firm. In such a case, managers could become too conservatives in their
estimates because they want estimates that they can beat. Moreover, managers tend
to give estimates with a low dispersion (central bias) because they believe that
according to their experience they should know what the values must be. One could
mitigate the motivational bias by including experts that do not belong to the firm and
have experience in the project line of business and/or by instructing the participants
in the potential bias in which they may incur.

Cognitive bias is related to the way experts perceive the value of critical
variables. This type of bias could take several forms: too much weight to recent
events, anchoring and adjustment (the experts give a value and only adjust a little
from it), the experts may make non-stated assumptions about the critical variable,
and so on. In this respect, Spetzler and Stael Von Holsteins have suggested a
procedure to avoid as much as possible motivational and cognitive bias29:

Motivating phase: In this stage all the participants are told about the potential bias
that may arise. The goal is to make the individuals conscious about their own
process of judgement.
Structuring phase: In this stage all the critical variables are clearly defined. The
goal is not only to understand the definition of each critical variable, but also to
make familiar this definition to the expert.
Conditioning phase: the main objective of this stage is to find out what are the
potential biases of the particular group of experts consulted. Some questionnaires
are performed to discover the motivational and cognitive biases in the group.
Once the biases are detected, one designs a strategy to avoid them as much as
possible. For example, if one detects that the group tend to have a central bias
problem one could ask for extreme values first.
Encoding phase: The main objective of this stage is to obtain the correlation
coefficients between variables and the subjective cumulative probability
distribution for each critical variable. For the former task one may use any of the
correlation assessment methods, while for the later task one may use the Wheel
of Probabilities.

The Wheel of Probabilities has two parts. In the frontal part of the wheel two
zones of different colors are painted and in the later part the probability values are
written. The procedure consists of making a series of questions to the expert with the
purpose of comparing the probability that the critical variable is smaller than certain
value and the probability that when turning the wheel the pointer finishes in a certain
zone. The process culminates in the point in which the expert considers that the
cumulative probability of both events is the same30.

29
Hull [19], and Salinas [42] discuss the Spetzler and Stael Von Holsteins procedure.
30
For a further description of the Wheel of Probabilities see Salinas [42].
 16

This way of eliciting experts opinions is appropriate because it is not advisable

to ask experts directly about the values that critical variables may take or about the
probability of a certain event. In this way one tries to avoid potential biases as much
as possible.

Provided with the subjective cumulative probability distribution for each critical
variable, one must find out which parametric probability distribution fits best the
subjective cumulative probability distribution. In order to perform this task one could
use the software Best-Fit31. This software, with the aid of goodness-of-fit tests, helps
to discover the parametric distribution that may reproduce the data with a degree of
confidence. The goodness-offit is defined as the probability of the data given the
parameters, so it gives the probability that a given distribution function generates the
data set.

This software offers three types of goodness-of-fit tests: the Chi-square, the
Kolmogorov-Smirnov, and the Anderson-Darling. Although the software is able to
estimate these tests, their estimation will depend on the way managers have the
information about the critical variable (sample, density or cumulative). The chi-square
test can be used with any type of input data (sample data, density or cumulative),
and with a continuous or discrete probability distribution. The weakness of this test is
that the conclusion varies with the number of classes (intervals) that are being
considered and there is no a guideline to select a suitable number of classes.

The Kolmogorov-Smirnov test can be used with any type of input data (sample
data, density or cumulative), but it only approximates to continuous probability
distributions. It doesnt depend on the number of intervals, but it doesnt detect very
well the tail discrepancies between distributions.

The Anderson-Darling test is very similar to the previous test, but with more
emphasis in the tail discrepancies between probability distributions. The only
weakness of this test is that it can only be used with sample input data.

From these characteristics one suggests the Anderson-Darling test whenever

historical information about the critical variable is available because usually in this
case one has historical sample data. Otherwise, it is advisable the Kolmogorov-
Smirnov test because one gets information about the critical variable using the
subjective cumulative probability functions obtained through the Wheel of
Probabilities.

The last two steps in the procedure depicted in figure 5 are the same as when
historical information is available. However the correlation coefficients must be
estimated using one of the correlation assessment methods. In the verifying stage
one corroborates whether the experts agree with the correlation coefficients in the
model, the general shapes of the parametric distributions and the subjective
parameters founded. If they agree, one assigns the parametric probability
distributions and the subjective parameters to the critical variables and one inserts
the dependencies among variables and values using the estimated correlation
coefficients, if such dependency exists. If the experts do not agree, one needs to
repeat the process for the critical variables the experts feel uncomfortable with.

31
Palisade Corporation [38].
 17

4.3 Simulation analysis

In general terms simulation means the reproduction of real situations with

simplicity. However, simplicity does not mean that the task is easy to accomplish
because one needs to take care of multiple relationships between critical variables in
the model. The simulation analysis recreates the input distributions through
sampling32. The simulation process varies simultaneously all the critical variables
within the specified ranges according to the parametric distributions assigned. This
process helps to find the project stand-alone risk.

Due to the repetitive nature of the simulation analysis, again it is advisable to

use specialized software to perform this task. Simulation analysis is a useful tool, but
not perfect. If the characterization and/or links between critical variables are wrong,
the outcome is useless (the garbage in, garbage out or GIGO principle). Hence, the
previous stages are extremely crucial in order to obtain useful results.

Figure 5 depicts the simulation process. The process starts with the feasibility
of the extreme cases considered within the simulation. Very often one does not
assess whether extreme situations considered in the simulation could occur in reality.
As Robichek and Van Horne [41] pointed out, any cash flow projection must be
based on some assumed management strategy valid within a specific scenario.
Usually, when managers conduct a simulation analysis the underlying management
strategy corresponds to the business-as-usual scenario. If the extreme cases do not
correspond to this scenario, one must consider more than one scenario into the
analysis.

The next step is the determination of the cumulative parametric distributions of

the critical variables. The software @Risk automatically executes this step that is
the first one into the loop represented by the dashed line. The software executes
repeatedly all the steps within the loop until the output variable converges.

A convergent situation is characterized by the stability of the parameters in the

probability distributions that belong to the output variable (the project return on
invested capital per period). Stability means that additional iterations do not markedly
change the shape or statistics of each sample distribution of the project FCF and
ROIC (one distribution per period across the project horizon). By comparing the
sample mean with the true mean that belongs to a perfect fit with the parametric
distribution, one is able to measure the degree of convergence. Of course, one could
also compare other statistics like standard deviation, skewness, and so on.

The convergent value per period is in fact an expected value where the
different iterations have equal probabilities of occurrence. Although the software
@Risk performs all the steps within the loop automatically, one needs to understand
what the software does, so one briefly explains the different steps within the loop. In
principle, one does not have to worry about the determination of the cumulative
probability distributions because the software does it automatically, but one needs to
specify the sampling scheme.

32
It may appear that simulation lacks objectivity, but the validation of its results ultimately lies in
hands of the researchers ethics (Kleindorfer, O Neill and Ganeshan [23]).
 18

Figure 5: The Simulation Process

IDENTIFICATION OF THE
CONVERGENT VALUES
FEASIBILITY OF THE
EXTREME CASES
CONVERGENCE
ACHIEVED

IDENTIFICATION OF
DETERMINATION OF THE ITERACTIONS THE VALUES FROM
CUMULATIVE PARAMETRIC UNTIL REACH THE PARAMETRIC
DISTRIBUTIONS CONVERGENCE DISTRIBUTION

STRATIFICATION
LATIN HYPERCUBE
OF THE
SAMPLING TRANSFORMATION
PARAMETRIC
(WITHOUT REPLACEMENT) OF RANDOM
DISTRIBUTIONS
NUMBERS INTO
CUMULATIVE
PROBABILITTIES
NO
STRATIFICATION
MONTE CARLO OF THE
SAMPLING PARAMETRIC
(WITH REPLACEMENT) DISTRIBUTIONS GENERATION OF
(CLUSTERING RANDOM NUMBERS
PROBLEM) IN EACH ITERACTION

In particular, the software offers two sampling schemes: Monte Carlo and Latin
Hypercube. Both schemes refer to artificial sampling in which any given sample may
fall anywhere within the range of the input cumulative distribution. Both sampling
schemes generate per iteration a random number between 0 and 100. This number
is transformed into a cumulative probability by dividing it for 100. The cumulative
probability is then used to identify the value of the critical variable. Next, the software
estimates the value of the output variable by combining the simulated values of the
critical variables according to the relationships specified in the model, while assigning
constant values for other variables. This process continues until it converges in the
terms described above.

It is important to point out that the Monte Carlo sampling needs more number
of iterations than the Latin Hypercube sampling to converge. If one performs a few
iterations the Monte Carlo sampling may cluster all the iterations in a particular region
of the cumulative distribution because this sampling scheme does not divide the input
distribution according to the number of iterations. The Latin Hypercube sampling
scheme stratifies the cumulative input distribution according to the initial number of
iterations that one specifies in the program, and it forces the iterations to be in a
different region of the cumulative input distribution. This feature plus the fact that is a
sampling scheme without replacement allows us to reach convergence with less
number of iterations.

Once the process has converged, the software automatically gives a report of
all estimated values for the input and output variables. The convergent values of the
output variable are useful to estimate a measure of the project stand-alone risk in the
next stage.
 19

4.4 Estimation of the project stand-alone risk

The final step is to estimate the project total risk. In principle, it could be
estimated using two measures of project returns: the internal rate of return (IRR) or
the return on invested capital (ROIC).

One may argue that it is better to measure the project total risk in terms of the
standard deviation of the project ROIC because it controls for the project size, it is a
better measure to understand the project performance as opposed to other return
measures like the return on assets (ROA) or the return on equity (ROE), and it can
be estimated per period and in a wide range of situations as compared to the project
internal rate of return (IRR). Due to these reasons, one focuses the explanation in the
project ROIC as output variable.

The project stand-alone risk (SAR) could be measured using two alternative
statistical measures: the standard deviation and the coefficient of variability. These
are surrogate measures of project risk because they are measures of variability
rather than risk per se. Nevertheless, it is well known that the greater the variability,
the greater will be the risk and vice versa. One may estimate the project stand-alone
risk or total risk using one of the two following measures:

Using the Standard Deviation (SD)

P
(
SAR t = ROICt
P
)
(
ROIC t
P
): Standard deviation of the project return on invested capital in period t

Using the Coefficient of Variability (CV)

( P)
ROIC t
P P
SAR t = CV ROIC t =( ) E ROICP
( t)
(
E ROICt
P
): Expected return on invested capital in period t

What is the best measure of the project stand-alone risk? The CV gives the
amount of risk per unit of return and the SD is a direct measure of the project total
risk. The SD is more flexible than the CV because it is easier to include it into
financial models (Bowlin [3]). However, both measures should prompt to the same
conclusion and both are suitable when the probability distribution of the project ROIC
is symmetrical. This implies that the standard deviation of a skewed distribution is not
enough to capture the risk involved. In such a case, there are two solutions: to
estimate the semi-variance (SV) or to estimate higher moments of the distribution.
The first solution is better because it is difficult to involve the skewness and higher
moments of the distribution into financial models.
 20

The semi-variance is estimated in the same way as the variance, but one only
considers the outcomes below the expected value (Mao [28]) 33:

) = E (ROIC ))
2

( (

SAR = SV ROIC
P
t
P
t
P
t E ROIC P
t

Whenever the difference inside the brackets is positive the expectation will be
zero and non-zero otherwise. In other words, the expectation operator is defined only
for negative values of the difference. Once the semi-variance of the project ROIC has
been determined, one can use it as a measure of the project risk34.

5. Estimation of project cash betas

This section introduces formal expressions that one may use to estimate
unlevered cash betas or forward-looking betas for non-well diversified investors and
well-diversified investors. Likewise, a formal expression to estimate the project risk-
adjusted hurdle rate for non-diversified entrepreneurs is also introduced. Finally, a
numerical application when all the dimensions of project risk are relevant and when
the project contribution to the within-the-firm risk is not relevant are discussed.

5.1 When all dimensions of project risk are relevant

Any sponsoring firm can be seen as a portfolio of projects and in this sense it
has a degree of within-the-firm diversification. The interesting question is whether the
additional investment project will contribute or not to further diversify this portfolio of
projects. One way to assess the impact of taking on a project in the sponsoring firm
is by estimating the firms total risk including the project ( ROICSF 1 ) in the following
way (Mao [27]):

2 ROICSF 1 = X 12 2 ROICSFo + X 22 2 ROICP + 2 X 1 X 2 ROICSFo ROICP ROICP ,ROICSFo ...(2)

Where:

ICP ICP
X1 = 1 , X2 = Are the investment ratios
ICSF ICSF

ICSF : Sponsoring firms expected invested capital including the project

IC P : Expected invested capital in the project
ROICSFo : Sponsoring firms expected total risk without the project
ROICP ,ROICSF : Expected correlation coefficient between the project returns and
o
the firms returns without the project.

33
The semi-variance could be readily estimated from the output of @Risk.
34
Mao [28] argues in favor of the semi-variance as a measure of risk in all cases because this is
consistent with the managers and entrepreneurs emphasis in the project downside risk.
 21

The correlation coefficient in expression 2 indicates whether the project

contributes to a further within-the-firm diversification or not. In general, the firms total
risk including the project depends on the project within-the-firm diversification effect
(correlation coefficient), the project relative size (investment ratios), the sponsoring
firms total risk without the project and the project total risk. If one multiplies and
divides by ROICSFo the last term of expression 2, one obtains the following
expression:

2ROICSF1 = X12 2ROICSFo + X 22 2ROICP + 2 X1X 2 2ROICSFo WF ...(3)

As one can see, there is a connection between the project within-the-firm beta
and the sponsoring firms total risk including the project. However, how can one
assess such impact from the market perspective? Brigham and Gapenski [4] have
proposed the following expression35:

LMSF 1 =
IC P
ICSF
( LMP ) + 1
IC P
ICSF
( LMSFo )
LM : Levered market beta of the sponsoring firm including the project
SF 1
LM : Levered market beta of the project
P
LM : Levered market beta of the sponsoring firm without the project
SFo

It is also possible to write the previous expression assuming an all-equity firm.

In this sense, one must use unlevered betas instead of levered betas. This change
produces the following expression:

UMSF 1 =
ICP
ICSF
(UMP ) + 1
ICP
ICSF
(UMSFo )
If one solves the previous expression for the unlevered market beta of the
project ( UMP ) and expresses the unlevered market betas using their ex-ante
definition (see figure 2), one gets the following expression36:

ICSF ROICSF 1 ICSF ROICSFo

UFLP = ROICSF 1,RM + 1 ROICSFo ,RM ...(4 )
IC P RM IC P RM

35
If one sees the market beta of the sponsoring firm as being a weighted average of individual
project betas.
36
It is possible to argue that this expression is an extension to the framework proposed by
Bierman and Hass [1]. These authors contend that what really matters in project valuation is
the project market risk except in the situation when there is an impact in the risk of financial
distress because in such a case the effect of the investment in the corporate sponsoring firm
must also be considered. Large and risky projects have the potential to increase the firms risk
of financial distress.
 22

It is interesting to observe that the project unlevered cash beta is obtained as

a weighted average of the sponsoring firms beta including the project and the
sponsoring firms beta without the project. In order to obtain the project cash beta,
one first estimates expression 2 and introduces the result into expression 4.

Due to the fact that one is dealing with forward-looking estimates instead of
historical estimates, the sponsoring firms total risk without the project and the project
total risk must be estimated using the procedure outlined in the previous section. This
implies that expression 4 will produce the project unlevered cash beta from the
managers perspective and not from the market or investors perspective. On must
remember that in a situation of incomplete markets there is no useful historical
information about the investment proposal, so one is left with the managers and
experts knowledge.

5.2 When the project contribution to the within-the-firm risk is not relevant

In this case the project consists in the creation of a new venture sponsored by
a group of well-diversified entrepreneurs, so only the project total risk and market risk
are relevant37. The project cash beta is estimated directly with the following formula:

ROICP
UFLP = ROICP ,RM ... ( 5 )
RM

As one can sees, in this case the estimation of the project cash betas is easier
than in the previous case because there is no firm sponsoring the project, so there is
no within-the-firm diversification effect. Besides, since the group of investors hold a
well-diversified portfolio of projects, so there is no project contribution to diversify
further their portfolio. Again, one must use the procedure outlined in section 4 to
estimate the project total risk.

In order to estimate the project cash betas, one needs to obtain the following
key variables: the expected market return and its volatility, the project return volatility
across years, and the correlation coefficients between the sponsoring firms returns
and the market returns or the correlation coefficients between the project returns and
the market returns. Since these variables are difficult to estimate in a forward-looking
way, the best suggestion is to wait in the application of equations 4 and 5 until better
methods to estimate these variables are devised.

5.3 When the project total risk is the only one dimension that matters

In this case one assumes that entrepreneurs put all their capital in their
investment adventures, so they are non-diversified. As Mongrut and Ramrez [32]
have shown, it is important to establish the proper reward-to-variability in order to
obtain one expression for the project risk-adjusted hurdle rate. This ratio depends
upon the entrepreneurs optimal choice among risk free deposits and investing in the
project, his coefficient of risk aversion and the project total risk.

37
If the entrepreneurs are non-diversified, only the project total risk would be relevant (Brigham
and Gapenski [4]). See subsection 5.3.
 23

If one assumes that the optimal choice for the investor is to put all his capital
into the project, one is dealing with the least risk-averse investor. Further, if one
assumes a coefficient of risk-aversion of 2 for the entrepreneur, and a project total
risk equal or higher than 50%, then the reward-to-variability ratio must be equal or
higher than one38. Taking the lower value for the reward-to-variability ratio (1), the
lower limit for project risk-adjusted hurdle must be Mongrut and Ramrez [32]:

Et [R t +1 ] R f + [ROICt +1 ]... ( 6 )

As with the previous two cases, it is also possible to estimate the project
hurdle rate for every period along the project horizon. However, in this situation, one
only needs the risk free rate and project total risk as crucial inputs. In fact, the project
expected added value will be an upper limit since the risk-adjusted hurdle rate is a
lower limit.

It is important to point out that the estimated project value will be a required
value and it will not be a market value. This cannot be considered a limitation since
even for well-diversified investors the true project market value will lie within an
interval, although a shorter one (Mongrut and Ramrez [32]).

5.4 Numerical application

In order to understand the first two cases, the next two tables provide
estimates of project cash betas only for one period when the sponsoring firm is a
diffusely held firm (e.g. corporate firm), and when the sponsoring firm is a closely
held firm, respectively. In all cases, it is assumed that the projects are being financed
with equity, so no debt is required39. Each table provides information about four
project risk-profiles: Research and Development (R&D) project, expansion project,
diversification project and replacement project.

Table 1: Project Risk-Profiles for Diffusely Held Firms

Type of Project R&D Expansion Diversification Replacement
Project Project Project Project
Investment Ratio 0.20 0.20 0.01 0.01
Var(Sfo) 0.25 0.25 0.25 0.25
Var(Rp) 0.23 0.25 0.30 0.25
Correl. (Sfo,Rp) 0.75 1.00 0.80 1.00
Bwf (1) 0.72 1.00 0.88 1.00
Var (Sf1) (2) 0.23 0.25 0.25 0.25
Var(Rm) 0.15 0.15 0.15 0.15
Correl. (Sf1, Rm) 0.45 0.50 0.50 0.50
Correl. (Sfo, Rm) 0.50 0.50 0.50 0.50
Project Cash Beta (3) 0.205 0.641 0.641 0.641
Implied Correl. (Rp, Rm) 0.17 0.50 0.46 0.50
Sfo Cash Beta (1) 0.641 0.641 0.641 0.641
Sf1 Cash Beta (1) 0.554 0.641 0.641 0.641

38
Normal coefficients of risk aversion usually range between 2 and 4 (Mongrut [32]).
39
The sponsoring firms total risk including the project only reflects changes in business risk.
 24

Table 2: Project Risk-Profiles for Closely Held Firms

Type of Project R&D Expansion Diversification Replacement
Project Project Project Project
Investment Ratio 0.60 0.60 0.20 0.10
Var(Sfo) 0.25 0.25 0.25 0.25
Var(Rp) 0.40 0.25 0.25 0.25
Correl. (Sfo,Rp) 0.50 1.00 0.90 1.00
Bwf (1) 0.63 1.00 0.90 1.00
Var (Sf1) (2) 0.23 0.25 0.28 0.25
Var(Rm) 0.15 0.15 0.15 0.15
Correl. (Sf1, Rm) 0.90 1.00 0.85 1.00
Correl. (Sfo, Rm) 1.00 1.00 1.00 1.00
Project Cash Beta (3) 0.991 1.282 0.607 1.282
Implied Correl. (Rp, Rm) 0.61 1.00 0.47 1.00
Sfo Cash Beta (1) 1.282 1.282 1.282 1.282
Sf1 Cash Beta (1) 1.108 1.282 1.147 1.282

Notes:

(1) The within-the-firm beta (Bwf) and the firms unlevered betas have been estimated using the
corresponding forward-looking definition of beta (see figure 2).
(2) The firms total risk including the project has been estimated using expression 2.
(3) The project unlevered cash betas have been estimated using formula 4.

In the case of R&D project it is assumed that it bears a total risk [Var(Rp)]
different than the sponsoring firm. However, it could be more or less risky depending
on different factors (e.g. line of business, competitive edge, etc). In particular,
Poterba and Summers [40] provide evidence that some R&D projects are less risky
than the sponsoring firms risk, while Hodder and Riggs [18] argue that sequential
R&D projects are riskier in their earlier stages.

From both tables one can see that the R&D project has a different cash beta
of that of the sponsoring firm without the project (Sfo). In the case of a diffusely held
firm, it has a lower unlevered beta (0.205 versus 0.641) because the project is less
risky (0.23 versus 0.25) and it contributes to the within-the-firm diversification (0.72)
and market diversification (from 0.50 to 0.45). In the situation of a closely-held firm, it
is assumed that the R&D project bears a higher total risk (0.40 versus 0.25), but it
also contributes to the within-the-firm diversification (0.63) and the market
diversification (from 1.0 to 0.90), so its unlevered beta is also below the sponsoring
firms beta without the project (0.991 versus 1.282). These results imply that formulas
2 and 4 are useful whenever a large R&D project offers diversification effects and
bears a different risk rather than the average-risk of the sponsoring firm without the
project [Var(Sfo)].

In the case of the expansion project, it is assumed that it does not contribute to
the within-the-firm diversification (Bwf). Under this assumption the three unlevered
betas involved in expression 4 are the same regardless on whether the firm is
diffusely held or not (0.641 and 1.282, respectively)40. This result could be seen as a
forward-looking version of the traditional average-risk case.

40
If the project offers a diversification effect the unlevered project beta will not be the same as
the sponsoring firms beta without the project, so one must use expressions 2 and 4.
 25

In the case of corporate firms, the diversification project aims to avoid the
firms risk of financial distress through diversification, while in the case of closely held
firms it aims to diversify the owners portfolio. In the former case, the diversification
project has the same cash beta as the firms without the project (0.641), while in the
later case it has a lower unlevered beta (0.607 versus 1.282). These results follow
from the relative size of the projects41. In the case of the closely held firm, the project
is relatively bigger, so the project diversification effects have greater impact in the
cash beta42. Hence, in the case of diffusely held firms it is possible to use the cash
beta of the firms without the project, while in the case of closely held firms it would
be better to use expressions 2 and 4. Replacement projects usually have the same
risk as the firms risk and they do not contribute to further diversify the existing
portfolio of projects. So, the project cash beta is equal to the firms cash beta without
the project. Besides, the relative small size of these projects reinforces this result.

It is also possible to use directly expression 5 to obtain the project cash betas
in the case of new ventures for well-diversified investors or to use expression 6 to
obtain the project risk-adjusted hurdle rate in the case of non-diversified investors. If
one assumes that the implied correlation coefficients reported in the tables are
applicable to new ventures, one should be able to obtain the same project cash betas
with the aid of formula 5. In summary, expressions 2 and 4 are useful for diffusely
held firms in the case of large projects with a total risk different than the average-risk
of the firm and with or without diversification effects. In the case of closely-held firms,
the proposed methodology is also useful for projects of any size that offer further
diversification to the firms owner even if the projects have the same firms average-
risk.

6. Estimation of the project risk-adjusted hurdle rate

In order to estimate the project risk-adjusted discount rate one needs to check
three different consistencies in the following order: consistency with the project
financial structure, consistency with the project fundamental risk and consistency with
the projection of prices. In this section I shall discuss briefly each one of them.

6.1 Consistency with the project financial structure

In order to choose the appropriate cost of equity capital expression, managers

need to consider the project financial strategy43. The reason for this is that is better to
apply the APV method under the strategy that targets the monetary unit level of debt
outstanding because one could deal easier with time-varying levels of debt, equity
and tax shields. Conversely, under the strategy that targets a constant debt to value
ratio, it is easier to use the WACC method because one deals with a constant debt to
value ratio44.

41
Due to its small size, the diversification project of the diffusely held firm cannot influence the
market diversification of the sponsoring firm.
42
Note that in the case of closely held firms, the market diversification and the within-the-firm
diversification are in favor of the firms owner.
43
It is assumed that the project desired financial structure is determined beforehand.
44
It is also possible to apply the APV method and the WACC method under both strategies and
obtain the same NPV provided that one uses the appropriate consistency formula in the
absence of capital market imperfections (see Mongrut [31]).
 26

For the WACC method one follows a two-step procedure: one estimates the
expected return on equity for a levered firm and then one uses this result to estimate
the expected levered risk-adjusted cost of capital. In this case it is not possible to
estimate directly the project levered risk-adjusted cost of equity capital because it
requires a levered forward-looking market beta and from expressions 2, 4, and 6 one
can only estimate unlevered project cash betas. The general set of formulas in the
case of the WACC method consists in the expected return on equity for a levered
firm (expression 7) and the project levered risk-adjusted cost of capital (expression
8).

RSL = R f + LFL (R m R f ).............(7 )

WACCP = R d (1 T )W d + RSL WS .....(8 )

Where:

Rf : Risk free rate

LFL : Project levered and forward-looking market beta
Rd : Cost of debt
T: Project tax rate
D
Wd = : Target debt to value ratio for the project
VL
S
Ws = : Target equity to value ratio for the project
VL

In the case of the APV method one only needs to estimate the expected return
on equity for an all-equity firm (expression 9). In this situation one can use directly
expressions 2 and 4 or expression 5 to obtain the unlevered project cash beta, which
will be used to estimate the project unlevered risk-adjusted cost of equity capital with
the aid of expression 9.

RsU = Rf + (Rm R f ) UFL ...............(9 )

Where:

UFL : Project unlevered forward-looking beta or cash beta.

6.2 Consistency with the project total risk

The consistency with the project total risk is implicitly recognized when one
uses the project total risk in expressions 2 and 4 or 5 to estimate the project cash
beta along the project horizon. Although, this procedure guarantees a connection
between the level of project discount rates and the project total risk, it does not
guarantee the objectivity of the estimations. Hence, one needs to struggle against
potential sources of bias permanently. Furthermore, it is very important to check that
the pattern of the project total risk corresponds with the pattern of risk-adjusted
discount rates along the project explicit forecast horizon.
 27

6.3 Consistency with the projection of prices

As it was stated in section 3, the consistency with the projection of prices does
not imply that one must obtain the same static NPV regardless on whether one uses
constant or nominal prices because this would imply inflation neutrality. This section
discusses the implications of inflation neutrality.

Inflation neutrality means that the inflation rate does not have any impact in
the project value. In particular, it assumes no inflation uncertainty, no corporate
taxes, and no project-specific price adjustments45.

In order to understand the implication of no inflation uncertainty lets define a

general specification that relates changes in the nominal interest rate with changes in
the real interest rate within the financial market46:

R fn = L1R f r + L2 . + L3 ..(10 )

R f r : Change in the real risk-free lending or borrowing rate

R f n : Change in the nominal risk-free lending or borrowing rate
: Standard deviation of inflation rate estimates

Inflation neutrality in formula 10 implies that either there is no inflation

uncertainty ( ) or L3=0, either the real risk free rate is constant ( R f r = 0 ) or L1=0,
and that L2=1. In words, changes in the nominal risk-free rate are only driven by
changes in inflationary expectations. Unfortunately, there is evidence that the real
risk-free rate has a negative relationship with the expected inflation rate
( R fr 0 ), that there is inflation uncertainty ( > 0 ) and that even there is
an inflation uncertainty premium (L3>0). Under this situation inflation neutrality does
not hold.

Now, lets see the implication of inflation neutrality in the estimation of the real
risk-adjusted hurdle rate. Under inflation neutrality, one could use the following
relationship between the real interest rate and the nominal interest rate47:

(1 + Rf n ) = (1 + Rf r ) * (1 + )...(11)
: Expected long-term inflation rate

In equilibrium and with the aid of expression 11, one can obtain the real risk-
adjusted required return on equity:

RSr = R f r + (R m R f r )...(12 )

45
Nelson [35] discusses the impact of inflation in the project risk-adjusted hurdle rate when
corporate taxes are present. Mehta, Curley, and Fung [30] discuss the same influence of
inflation when project-specific price adjustments and inflation uncertainty are present.
46
This part of the exposition is based in the explanation given by Mehta, Curley and Fung [30].
47
One must remember that only the nominal interest rate is observable, not the real rate.
 28

Formula 12 assumes that the real interest rate is constant. From expression
10 one may contend that the real interest rate is not risk-free (due to the presence of
inflation uncertainty), so expression 11 cannot not hold and one cannot obtain the
real risk-adjusted cost of equity capital using expression 1248. This result also implies
that one cannot convert nominal risk-adjusted cost of equity capital into real risk-
adjusted cost of equity capital using formula 11 because it doesnt hold and it will
introduce bias in the estimation of real risk-adjusted cost of equity capital.

Now, lets assume that there is no inflation uncertainty and that one can
convert nominal risk-adjusted hurdle rates into real rates using expression 11. In
order to see the impact of corporate taxes (T) in the project NPV, lets assume a one-
period irreversible investment, whose initial investment (I) is fully depreciated in one
year49. In this case, the static NPV in constant prices is the following:

FCFo T (FCFo I )
NPV = I + ...(13 )
1 + RSr

If the project free cash flows (FCF) are subject to constant inflationary
expectations ( ) the previous expression becomes:

(1 T )FCFo
(1 + RSr )(1 + ) ...(14)
TI
NPV = I + +
(1 + RSr )
Due to the fact that the depreciation is based on historical costs (period zero)
and not on the current costs (period one) there is a distortion generated by the tax
shield. Hence, the project NPV in nominal and in real prices will differ.

The impact of project-specific price adjustments into the project NPV can be
analyzed by assuming that project revenues (R) and costs (C) respond with different
degree of sensitivity (s1 and s2, respectively) to inflationary expectations. In the
presence of corporate taxes and project-specific price adjustments, the static NPV
can be stated as follows:

(1 T )[(1 + s1 )(Ro ) (1 + s 2 )(Co )]

(1 + RSr )(1 + ) ...(15)
TI
NPV = I + +
(1 + RSr )(1 + )
In this case the price distortion is even bigger because both terms on the right-
hand side of expression 15 contribute to increase the difference between the NPV in
nominal prices and the NPV in constant prices. The fact that one does not obtain the
same static NPV just means that inflationary expectations are non-neutral with
respect to the project value. In such case, there must be inflation uncertainty,
corporate taxes and project-specific price adjustments that managers must deal with.

48
Expression 12 also implies that the real risk premium is unaffected by inflation uncertainty.
49
This part of the exposition is based in the explanation given by Nelson [35].
 29

Due to the asymmetric impact of inflationary expectations into the project

value, several authors have advocated for the estimation of the project added value
in nominal or current prices50. The main arguments in favor of this suggestion are the
following51:

Inflation neutrality does not hold, so project evaluation in current or nominal prices
and in constant or real prices will not yield the same result. Due to the fact that
nominal rates are observable, it is clearer to estimate the project NPV in current
prices.
Nominal rates are more intuitive than real rates because they belong to the usual
language of managers and investors.
Forecasts of market returns and market interest rates are made in nominal terms
because historical nominal rates are used as reference.
It could be that historical and nominal financial information is useful to forecast
items that belong to the project cash flow.

Given the preference for project valuation in nominal prices, one may wonder
how the nominal risk-adjusted discount rate must be estimated in such a way that it
allows for project-specific price adjustments and inflationary uncertainty. Friend,
Landskroner, and Losq [11] have proposed a modified version of the CAPM to
account for project-specific price adjustments by adding a relationship between
expected inflation, expected project returns and expected market returns52. Their
approach can be implemented within the proposed methodology, but one also needs
to gather information about inflationary expectations.

7. Estimation of the project expected added value

The last phase of the proposed methodology consists in the estimation of the
project added value. The estimation of the project static NPV can be accomplished
by using either the APV method or the WACC method. However, a crucial difference
between them is the treatment of the financial effects, specifically the tax shield53.
The WACC method recognizes the financial effect in the risk-adjusted cost of capital,
while in the APV method treats the financial effect as a cash flow. The estimation of
the project expected added value under the WACC method could be stated as
follows:

n FCFt SVn
E (NPV ) = I + +
(
t =1 1 + WACCP )t (1 + WACCP )n
This expression discounts unlevered free cash flows (FCF) at the levered risk-
adjusted weighted average cost of capital (WACCp). Furthermore, it recognizes the
possibility of a salvage value ( SV ) at the end of period n.

50
See Copeland, Koller and Murrin [7], and Mehta, Curley and Fung [30].
51
Copeland, Koller and Murrin [7] gave some of these suggestions.
52
Mehta, Curley and Fung [30] have extended the work of Friend, Landskroner, and Losq [11]
by incorporating inflation uncertainty into the analysis. Their formula can also be applied within
the proposed methodology, but one also needs to forecast nominal interest rates.
53
The APV method is able to handle other effects beyond the project tax shields.
 30

The estimation of the project expected added value under the APV method is
stated as follows:

n FCFt SVn n R d Dt
E (NPV ) = I + + +T
(
t =1 1 + RsU )t (1 + RsU )n (
t =1 1 + K )t
In this expression one also discounts unlevered free cash flows (FCF), but at
the unlevered risk-adjusted discount rate (Rsu). Besides, the tax shield is treated as
a cash flow, amount of debt (D) times the cost of debt (Rd), and it could be
discounted at a different rate (K)54. Interestingly enough, both expressions assume a
finite horizon n and do not include any market imperfection such as Access Gain
(AG), Financial Distress Cost (FD), and Agency Cost (AC)55. Despite the fact that it is
very difficult to estimate these imperfections, the APV method seems the most
suitable way to deal with them using the following expression56:

n FCFt SVn n R d Dt
E (NPV ) = I + + +T + AG FD AC...(16 )
(
t =1 1 + RsU )t
(1 + RsU )n
(
t =1 1 + K )t

From the three additional terms, the easiest one to estimate is the Access
Gain (AG), which occurs when investors finance the project with a subsidized interest
rate below the market debt interest rate ( Rdm ). For example, this may be obtained
thought special programs offered by international credit institutions. The appropriate
discount rate is Rdm because this is the rate at which managers must borrow
instead of the subsidized rate that they are receiving.

The project Access Gain (AG) can be estimated using the following
expression:

n Quotat
AG = D
t =1 (1 + R dm )t

D: Initial debt
Quotat : Periodic payment

Unfortunately, there is no exact method to measure the last two terms of

expression 16 neither to include the three of them into the WACC method.
54
The choice of k depends on the assumed uncertainty of the tax shield. If the tax shields are
uncertain, they will be as risky as the unlevered FCF and they must be discounted at Rsu. If
the tax shields are certain, they will be as risky as debt and they should be discounted at Rd.
55
In the case of projects with an infinite life one must replace the project salvage value by the
corresponding continuing value (See Copeland, Koller and Murrin [7]).
56
Furthermore, non-diversified entrepreneurs must use the APV method instead of the WACC
method because the project discount rate is not a cost of capital, but a required return.
 31

8. Limitations and future lines of research

The main limitation of the proposed methodology is related to the estimation of
unlevered project cash betas without considering the project contribution to increase
the firms risk of financial distress. This limitation is due to the lack of a relationship
between the project financial risk and the firms business risk including the project.
Indeed, the establishment of such relationship represents an interesting research and
it would be interesting to see whether such a relationship could be incorporated into
the proposed framework. Other limitations of the methodology are those linked to the
assumptions made in the introductory part: the assumption of no external financial
constraints, no synergies among projects, no capital rationing, and the absence of
managerial flexibility or real options. Nevertheless, these limitations could also be
seen as further extensions of the proposed methodology.

The assumption of no financial constraints is consistent with the fact that the
proposed methodology does not consider changes in the firms risk of financial
distress. In other words, the firm may borrow money for different projects without
having concern about its risk of financial distress. This situation is clearly not realistic,
so an extension must be made in order to account for the presence of financial
constraints and the possibility of changes in the firms risk of financial distress.

The absence of synergies among projects simplifies the explanation of the

methodology because it allows us to consider each independent project in isolation.
However, this situation is not likely to hold for all projects in the case of corporate
firms because corporate managers could also undertake investment projects
because they foresee interesting synergies among investment proposals. In this case
the proposed methodology is also useful, but one must use integer programming in
order to select the set of complementary projects to be accepted. The possibility that
managers practice capital rationing can also be handled within this framework.

Perhaps one of the most challenging extensions of the proposed methodology

is the introduction of managerial flexibility or real options. As it was pointed out, the
Real Option approach aims to estimate the project certainty-equivalent payoffs by
assuming risk-neutral investors and using risk-neutral probabilities.

It is possible to argue that certainty-equivalent cash flows can also be obtained

by subtracting the estimated project risk premium from the project risky cash flows.
However, how could managers assess the appropriate project risk premium? The
proposed methodology throws light into the issue by suggesting that the project risk
premium per period will depend on the variability of cash flows per period within a
particular scenario.

The methodology has been introduced assuming the surprise-free or

business-as-usual scenario for simplicity, but the analysis could be repeated under
different scenarios. According to Wack [48], one could build broad scenarios by
analyzing predetermined facts (events that have occurred or are about to occur, but
whose consequences are still uncertain) and uncertain elements (possible
consequences). Next, one constructs focused scenarios to the particular investment
project in which one identifies the specific critical variables within each scenario.
 32

The proposed methodology also offers some contributions: it establishes a link

between the project risk and the project cost of equity capital including diversification
effects, it constitutes an alternative when the short cut approach cannot be used for
well-diversified investors and for non-well diversified investors, it can be applied for
non-diversified entrepreneurs in emerging markets, it integrates different tools of the
customary approach, it forces managers and entrepreneurs to think about the
determinants of the project risk and profitability, and it offers a consistent basis upon
which they can justify their choice.

9. Conclusion
In this research one proposes a methodology that managers and
entrepreneurs could follow to evaluate investment projects whenever they cannot find
or use a suitable tradable benchmark to span the project risk. This methodology
integrates the tools used by the customary approach, for well-diversified investors
and non-well diversified investors it uses an equilibrium model (i.e. The CAPM) to
derive a clear-cut investment rule. Likewise, one uses a risk-adjusted hurdle rate in
order to estimate the required project value for non-diversified entrepreneurs.

One has explained the process to conduct a proper project risk analysis, how
managers and experts information can be used to obtain the project total risk, and
how the estimation of the project risk-adjusted discount rate may differ according to
the investors degree of diversification. More importantly, the methodology goes
beyond the average-risk case by establishing a connection between the project risk
and the project risk-adjusted discount rate through the estimation of cash betas or
through the estimation of a project hurdle rate.

Although, one must wait to apply the results corresponding to well and non-
well diversified investors, the result related to the project hurdle rate may be readily
apply for the case of non-diversified entrepreneurs in incomplete markets. It can be
applied on a project basis and it does not require assumptions about return
distributions or even the existence of a capital market. Country risk could be
accommodated through scenario analysis and be embedded into the project total
risk. Most importantly, this methodology can be applied for the vast majority of firms
in emerging economies.

The methodology also has limitations, specially related to the cases of well-
diversified and non-well diversified entrepreneurs, but hopefully most of them could
be translated into extensions. Some possible extensions are the inclusion of
managerial flexibility, synergies among projects, capital rationing, and the project
contribution to the firms risk of financial distress. All these extensions are challenging
and interesting to pursue. All in all, this research has outlined the theoretical
framework of a possible managerial tool whose practical implications are still to be
found.
 33

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