Determining Venture Participation
Authors: Greenwalt Wayne A. 
Published: December 2007

A practical method to determine venture participation that incorporates profitability and risk participation that incorporates profitability and risk investment is presented. Corporate planners also may use this method to evaluate potential risk investments in exploratory trends to maximize profitability and minimize the risk of financial failure caused by "gambler's ruin."

Introduction

The law of gambler's ruin states that there is a chance of going broke merely by a normal run of bad luck, regardless of the long-run expectations. Gambler's ruin is avoided by having sufficient capital to continue to participate in numerous ventures and ride out the run of bad luck.Several methods used to avoid gambler's ruin require the determination of the decision maker's aversion to risk. In these methods, the decision maker's aversion to risk is described by one of the following terms: level of significance, level of confidence, level of risk aversion, or utility curve. An average value for a decision maker's aversion to risk is obtained in most methods by a review of historical decisions. This average value then is used to determine the decision maker's participation in prospective ventures. An underlying assumption in prospective ventures. An underlying assumption in this process is that a decision maker's aversion to risk will remain unchanged for different levels of profitability and risk investment. In an attempt to profitability and risk investment. In an attempt to alleviate this inherent limitation, many decision makers use their intuition to adjust the average value of risk aversion for profitability and risk investment or rely completely on their intuitive judgment to determine venture participation.A more practical alternative is a method that determines venture participation when the decision maker's level of risk aversion varies according to venture profitability and total risk investment. In this method, decision makers determine their fundamental aversion to risk in all ventures when the expected profit equals the risk investment in each venture. All ventures meet this condition when a decision maker compares the discounted payout of each venture. A decision maker's selection of a desired working interest for any venture that anticipates only a discounted payout establishes the decision maker's fundamental aversion to risk. This desired working interest for any venture that anticipates only a discounted payout will remain unchanged when venture participation in all ventures is determined unless there are fiscal constraints on the maximum desired risk investment for any venture that anticipates only a discounted payout.

Concept and Theory

Venture participation is determined after a thorough review of the interrelation of these criteria:venture profitability,total risk investment,aversion to risk,probability of success, andavailable risk investment funds.

Eqs. 2, 3, and 5 interrelate these five criteria. Development of the first equation is based on this equality:

probability of probability of probability of probability of financial failure - all dry holes

This equality is based on the assumption that gambler's ruin will occur when all wells drilled are dry holes. However, it is possible to have a few successful wells that are incapable of preventing gambler's ruin.

JPT

P. 2189