Investment management is a decision-making process which ranges from an individual managing his own small portfolio of securities to institutional investors who manage portfolios valued in millions of dollars. The importance of investment management is readily observed in the increased activity of the securities markets, the close scrutiny given by regulatory agencies to various institutional investors and professional investment managers, the growing market value of pension funds, trust funds, and investment companies, and finally, the increasing number of related research studies which are reported in the financial literature.

The use of the expected utility hypothesis and the “portfolio approach” has recently become quite popular by both writers in monetary theory and in financial management. Most discussions are given within what might be called the Tobin-Markowitz framework. One very important result recently discussed at some length is the Tobin “separation theorem.” This theorem essentially says that a quadratic preference function, or a normal distribution of returns on risky assets is a sufficient condition for the proportions of the various risky assets in a portfolio to be independent of the proportion of the portfolio held in a safe asset. The proofs of this theorem are given within a framework of the decision maker who minimizes portfolio variance for a given portfolio return, using variance as a measure of risk of the portfolio.

This paper investigates how the addition of debt to the capital structure of a corporation affects the risk of the stockholders. In the first instance, we will hold the size of the firm constant and substitute debt for common stock. In the second situation, we will allow firm size to change, and will accomplish the increase in size by issuing debt. For both situations, we will first observe the effect of debt on the earnings per dollar of common stock investment. The analysis could also be made using the number of shares of common stock. Since the number of shares of common stock may be changed quite arbitrarily (as, for example, by stock dividends), we want to make the measure invariant to the number of shares outstanding. We will do this by using value of common stock and value of debt. We are then computing the variance of return on common stock investment when we compute variance of earnings per dollar of common stock investment. After considering how debt affects earnings per dollar of stockholders' investment, we will investigate the effect of debt on the total earnings of the stockholders, and on the probability of a deficit.

The application of linear programming techniques to the problem of capital budgeting has repeatedly been proposed in the literature. However, while the potential of linear programming models for this important area of business decisions is generally recognized, practical applications still face some severe limitations. This note focuses on one particular problem peculiar to the application of programming techniques to capital budgeting, namely the mutual dependence between the optimal solution of the linear programming model and the discount rate used to calculate the coefficients of its objective function.

Two measures of investment worth: the discounted-rate-of-return and the payback method will be compared here. Many examples can be found in the literature illustrating the serious limitations of the payback method.

According to these examples, an investment proposal may be judged economically undesirable when in actual fact it is highly profitable. This happens when the annual cash flow is not equal, and the investment project promises a relatively large cash flow after the cut-off period.

Although the importance of evaluating the risk of potential investments has long been recognized, only recently have formulations been developed to include risk as an explicit variable in the decision-making process. The considerable progress being made in this area, both in theory and in application, is attested to by the number and variety of contributions to the literature.

Corporations tender for their own shares for a variety of reasons. Some stock tenders are made for strategic purposes—to prevent a take-over, to raise the market price of the stock, or simply because the stock represents ‘a good investment.’ For discussion of tendering in these situations, see the articles of Ellis [2] and Guthart [1]. In addition, there may be tactical reasons for a stock tender; one such reason is to reduce bookkeeping and shareholder servicing costs. In this instance, the argument runs roughly as follows: “The annual cost of servicing a holding is independent of the number of shares; consequently, the cost per share of servicing small holdings is relatively great. Let us reduce these high per-share costs by buying up small holdings.” Typical procedure is to then mail out an offer to buy holdings of less than a certain size directly, thus permitting the shareholder to dispose of his holding without paying the usual brokerage and odd-lot fees. Frequently no premium is offered except for the avoidance of brokerage fees. If one were to consider the premium offered as a controllable variable, it would be surprising to discover that its optimal value were exactly zero. One also recognizes that the maximum shareholding tendered for may be another decision variable available for optimization. See the appendix for data on tenders of this sort made in recent years. The variety of policies seems to indicate an almost complete absence of systematic application of the ideas presented here.

Professor Solow's article, “Technical Change and the Aggregate Production Function,” now virtually classic, has made a great impact on economists generally and in the last few years the subject has received unprecedented attention in economic literature. The reason for this extraordinary emphasis on “Technical Change” has been the conclusion—in Solow's above-mentioned article—based on statistical evidence, that gross output per man-hour in the United States nonfarm economy doubled over the period 1909–1949, “with 87.5 percent of the increase attributable to technical change and the remaining 12.5 percent to increased use of capital.”

In “Valuation Under Uncertainty,” which recently appeared in this Journal (September 1967), Houng-Yhi Chen argues [1, pp. 313–314] that “Robichek and Myers' criticism [2, 3] of the use of the risk-adjusted discount rate is unfounded,” and suggests that our “conclusions must be based in part on a misunderstanding of the risk-adjusted discount rate method.” These charges are without foundation, as we will show here.