Measuring and Utilizing Corporate Risk Tolerance to Improve Investment Decision Making

Author: Walls, Michael

Source: The Engineering Economist, Volume 50, Number 4, October-December 2005 , pp. 361-376(16)

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Abstract:

Strategic investment decisions are generally characterized by financial risk as well as an irrevocable commitment of significant amounts of capital. The firm's willingness to undertake financial risks plays an important role in the investment decision making process. A comprehensive economic decision analysis to evaluate strategic investment decisions requires a measure of the firm's tolerance for financial risk. This article describes a decision analysis–based technique for assessing managerial risk tolerance as well as managers' ability to be consistent in terms of their financial risk taking. These assessments are then utilized to assist the firm in establishing a corporate risk policy that can guide strategic decisions under uncertainty. The study firm is a business unit within a U.S.-based major oil company with an annual capital budget of approximately $400 million. Our findings suggest that managers are generally risk averse but struggle in terms of being consistent in their financial risk-taking decisions. This work enabled the firm to implement a financial risk tolerance that could be utilized in the economic decision analysis of investment decisions.

Document Type: Research article

DOI: http://dx.doi.org/10.1080/00137910500348434

Affiliations: 1: Division of Economics & Business, Colorado School of Mines, Golden, Colorado, USA

Publication date: 2005-10-01