Capital budgeting professionals continue to look to the CAPM and APT to determine project discount rates, in spite of compelling evidence that firms ignore these models in practice. One explanation is that many types of idiosyncratic risk are either (a) held by risk-regulated financial institutions, (b) not diversifiable, (c) exist in an incomplete markets setting, or (d) are held by nondiversified controlling investors, any of which would imply that idiosyncratic risk would be priced. This paper develops a new riskadjusted present value method (RPV) that explicitly considers the cost of idiosyncratic risk in a multiperiod setting. The results include a new pricing formula which nests the traditional NPV formula, and an allocation of risk charges across time for better risk-based decision-making, capital allocation and valuation projections.
Dr. David Shimko has been involved with commodities, credit, risk management and derivatives for over 30 years. While head of Commodity Derivatives Research at JPMorgan in the 1990s, he published a monthly column in Risk Magazine and frequently appeared in Energy Risk. At Bankers Trust, he headed a client risk advisory unit, and later cofounded Risk Capital, an independent consulting firm. David has co-authored three issued patents in credit risk management, and has published widely in the academic and trade literature. Concurrent with his professional career, he has taught at USC, Kellogg, HBS and NYU Courant. He is currently Full Professor of Finance at the NYU Tandon.