Project Valuation under Ambiguity

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