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Evaluating Income Streams: A Decision Analysis Approach

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  • James E. Smith

    (Fuqua School of Business, Duke University, Durham, North Carolina 27708-0120)

Abstract

Most important decision problems---virtually all capital investments and planning situations---involve risky cash flows with uncertainties that are resolved over time. In most of these problems, the decision-maker has access to financial markets and may borrow and lend to smooth consumption over time. Yet, because of the difficulty of incorporating these borrowing and lending decisions into the evaluation models, these opportunities are rarely explicitly modeled in decision and risk analyses of these investments. In this paper, we study the errors induced by failing to account for these borrowing and lending decisions, and we develop extensions to the standard decision and risk analysis procedures that, given certain market and preference assumptions, take these borrowing and lending opportunities into account without overburdening the evaluation models.

Suggested Citation

  • James E. Smith, 1998. "Evaluating Income Streams: A Decision Analysis Approach," Management Science, INFORMS, vol. 44(12-Part-1), pages 1690-1708, December.
  • Handle: RePEc:inm:ormnsc:v:44:y:1998:i:12-part-1:p:1690-1708
    DOI: 10.1287/mnsc.44.12.1690
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    File URL: http://dx.doi.org/10.1287/mnsc.44.12.1690
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    References listed on IDEAS

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    1. Kreps, David M. & Porteus, Evan L., 1979. "Temporal von neumann-morgenstern and induced preferences," Journal of Economic Theory, Elsevier, vol. 20(1), pages 81-109, February.
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    4. Mossin, Jan, 1969. "A Note on Uncertainty and Preferences in a Temporal Context," American Economic Review, American Economic Association, vol. 59(1), pages 172-174, March.
    5. Ronald A. Howard, 1988. "Decision Analysis: Practice and Promise," Management Science, INFORMS, vol. 34(6), pages 679-695, June.
    6. Machina, Mark J., 1984. "Temporal risk and the nature of induced preferences," Journal of Economic Theory, Elsevier, vol. 33(2), pages 199-231, August.
    7. James E. Smith & Robert F. Nau, 1995. "Valuing Risky Projects: Option Pricing Theory and Decision Analysis," Management Science, INFORMS, vol. 41(5), pages 795-816, May.
    8. Pratt, John W & Zeckhauser, Richard J, 1989. "The Impact of Risk Sharing on Efficient Decision," Journal of Risk and Uncertainty, Springer, vol. 2(3), pages 219-234, September.
    9. Chew, Soo Hong & Epstein, Larry G, 1989. "The Structure of Preferences and Attitudes towards the Timing of the Resolution of Uncertainty," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 103-117, February.
    10. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, vol. 46(1), pages 185-200, January.
    11. Spence, Michael & Zeckhauser, Richard J, 1972. "The Effect of the Timing of Consumption Decisions and the Resolution of Lotteries on the Choice of Lotteries," Econometrica, Econometric Society, vol. 40(2), pages 401-403, March.
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