Required Return on Investments in Construction

Abstract

Construction risk is exposure to possible economic loss arising from involvement in the construction process. A unified‐field‐theory classification of the risk‐adjusted discount rate (RADR) methods demonstrates that modern portfolio and capital‐market theories can be translated into RADR models. Project in market context, firm in market context, and project in firm context assume perfect (efficient) capital market. The first two claim unsystematic risk is irrelevant. Project in firm context assumes that only marginal unsystematic risk of the project is relevant. Project in isolation, which is based on the total risk of the project, is not an optimal investment policy. Project in firm context is not practicable due to realworld constraints. Project in market context is theoretically superior. However, the systematic risk index, beta, cannot be easily determined. Therefore, for a simple accept/reject decision, firm in market context resulting in an average cost of capital is the only practicable alternative for determining the required rate of return.