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Corporate investment policy

In: Handbook of the Economics of Finance

Author

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  • Brennan, Michael J.

Abstract

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

Suggested Citation

  • Brennan, Michael J., 2003. "Corporate investment policy," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 3, pages 167-214, Elsevier.
    • Handle: RePEc:eee:finchp:1-03
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    Cited by:

    1. Christian Bach & Peter O. Christensen, 2016. "Consumption-based equity valuation," Review of Accounting Studies, Springer, vol. 21(4), pages 1149-1202, December.
    2. Rainer Baule, 2019. "The cost of debt capital revisited," Business Research, Springer;German Academic Association for Business Research, vol. 12(2), pages 721-753, December.
    3. Alibeiki, Hedayat & Lotfaliei, Babak, 2022. "To expand and to abandon: Real options under asset variance risk premium," European Journal of Operational Research, Elsevier, vol. 300(2), pages 771-787.
    4. Alexander, David Richard & Mo, Mengjia & Stent, Alan Fraser, 2012. "Arithmetic Brownian motion and real options," European Journal of Operational Research, Elsevier, vol. 219(1), pages 114-122.
    5. Chen, Fan & Linn, Scott C., 2017. "Investment and operating choice: Oil and natural gas futures prices and drilling activity," Energy Economics, Elsevier, vol. 66(C), pages 54-68.

    More about this item

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance

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