Project Valuation in Mixed Asset Portfolio Selection

We examine the valuation of projects in a setting where an investor, such as a private firm, can invest in a portfolio of projects as well as in securities in financial markets. In project valuation, it is important to consider all alternative investments opportunities, such as other projects and financial instruments, because each imposes an opportunity cost on the project under consideration. Therefore, conventional methods based on decision analysis may lead to biased estimates of project values, because they typically consider projects in isolation from other investment opportunities. On the other hand, options pricing analysis, which does consider financial investment opportunities, assumes that a project's cash flows can be replicated using financial assets, which may be difficult in practice. The main contribution of this paper is the development of a procedure for project valuation in a setting where the firm can invest in a portfolio of projects and securities, but where exact replication of project cash flows is not necessarily possible. We consider both single-period and multi-period models, and show that the valuation procedure exhibits several important analytical properties. We also investigate the pricing behavior of mean-variance investors through a set of numerical experiments.