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A GLUM Primer: The Risk-Adjusted Expecte...

Pfeifer, Phillip E...

Technical Note

A GLUM Primer: The Risk-Adjusted Expected Value

Pfeifer, Phillip E.; Bodily, Samuel E.; Baucells, Manel

QA-0849 | Published August 11, 2016 | 9 pages Technical Note

Collection: Darden School of Business

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The purpose of this note is to improve on the expected value criterion by incorporating a rational decision-maker's willingness and capability to take on risk. First, this note will review the concept of expected net present value (ENPV) and demonstrate its limitations. Next, we introduce the notion of play capital, or the most one is willing to put at risk in view of one’s life circumstances, goals, and resources. Then, we introduce the general logarithmic utility model (GLUM), a concave transformation that will produce the risk-adjusted ENPV. We demonstrate that the adjusted ENPV is always smaller than the ENPV. Finally, we show that a useful measure of riskiness of a project is the minimum play capital for which the adjusted ENPV is positive.