Corporate Risk Tolerance and Capital Allocation: A Practical Approach to Implementing an Exploration Risk Policy
Authors: Walls Michael R. 
Published: December 2007

This paper describes a model that provides the petroleum exploration company with a systematic approach to measure corporate risk tolerance (RT) and to implement a coherent risk policy, thereby improving the quality of risky decision making.

Introduction

Petroleum exploration companies are confronted regularly with the issue of allocating scarce capital among a set of available exploration projects, which are generally characterized by a high degree of financial risk and uncertainty. Commonly used methods for evaluating alternative investments consider the amount and timing of the monetary flows associated with a project and ignore the firm's ability or willingness to assume the business risk of the project. The preference-theory approach1,2 combines the traditional means of project valuation, net present value (NPV) analysis, with a decision-science-based approach to risk management. This integrated model provides a means for exploration firms to measure and to manage the financial risks associated with petroleum exploration, consistent with the firm's desired risk policy.

Risk management decisions associated with exploration capital allocation are among the most conceptually difficult decisions faced by managers. Exploration investment opportunities are often very different in terms of their risk characteristics. Because of these differences and the importance of evaluating competing investment alternatives, it is important for managers to use a formal and consistent means of evaluating projects. Setting corporate risk policy is an important component of managing the process of project evaluation. The work described here contributes to the areas of preference-theory application and capital budgeting decisions by providing explicit and systematic methodologies for measuring the firm's RT. The formal use of a corporate risk policy, measured by financial RT, coupled with a decision-science-based valuation model can go a long way toward improving the quality of decisions associated with capital allocation.

Capital Budgeting Under Uncertainty

The capital budgeting problem holds a very prominent place in both the theory and practice of corporate finance. In a world of certainty, widespread agreement exists among financial theorists that choosing among independent and mutually exclusive projects on the basis of NPV is consistent with owner wealth maximization.3,4 An important attribute of real-world decision making, however, is the risk and uncertainty associated with future outcomes. Modern finance theory views capital markets as the fundamental mechanism for spreading these risks. In other words, the individual investor has the ability to construct a portfolio that adequately diversifies "business-specific" risk, and managers of the firm should only be concerned about nondiversifiable, or "market," risk.5 Within this theoretical framework, managers in publicly held firms should maximize shareholder value by selecting those investment opportunities that have the highest expected NPV.

Rigorously applied, the theory suggests that corporate resources devoted to managing the business risks associated with capital allocation are used inappropriately. However, corporations appear to take risk management very seriously; recent surveys find that risk management is ranked by financial executives as one of their most important objectives.6 Observations of corporate risk management activities also suggest that considerable disparity exists between the prescriptive theory of finance and actual corporate decision-making behavior. This dilemma can be examined from empirical, theoretical, and behavioral perspectives.

The foundation of modern finance theory has been the Sharpe, Lintner, and Black capital asset pricing model (CAPM),4 which provides the basis for determining the appropriate discount rate to adjust for the nondiversifiable risks that the ownership of a particular stock brings to the investor's diversified portfolio. Unfortunately, this theory has not been supported by empirical evidence. Fama and French7 determined that no detectable relation exists between portfolio betas and average returns. Roll and Ross8 raise additional challenges to the CAPM and conclude that "… it is not of practical value for a variety of applications including the computation of the cost of capital and the construction of investment portfolios." Financial theory. concludes that each capital investment project should have a unique discount rate, but no guidelines exist for determining this rate. According to the popular finance textbook by Brealey and Myers,5 "… we as yet have no general procedure for estimating project betas. Assessing project risk is therefore still largely a seat-of-the-pants matter."

Studies of risky choice within organizations show that firms displays significant degree of risk aversion. March and Shapira9 argue that if firm performance is above some critical performance target, managers attempt to avoid actions that produce below-target performance (i.e., risk aversion); this reflects a strong sentiment for survival. Hackett10 noted that assuming that managers are merely agents for shareholders is unrealistic. Instead, managers attempt to reconcile the interests of all stakeholders, including themselves, employees, suppliers, and customers.

Swaim11 assessed utility functions for a group of 100 executives in a large industrial organization and found the overall attitudes toward risk to be strongly risk-averse. Spetzler12 interviewed 36 corporate executives in a major integrated oil company and consistently found risk-averse attitudes among individuals and within the managerial group as a policy-making body. In a study of oil executives, Wehrung13 found that more than half gave responses that were fully consistent with preference theory and that an additional quarter of the executives were consistent within a 10% margin of error. Capital investments are often technically evaluated on the basis of expected-value analysis. However, actual capital allocation decisions involving risky investments, whose consequences are significant, appear to be strongly affected by risk-averse decision behaviors.