Utility Theory
On the basis of SD and ENPV, it is difficult to say whether a decision maker should choose a project with a high expected values and a high SD or a project with a comparatively low expected value and a low SD. The decision maker's choice would depend upon his risk preference. Individuals and firms can be grouped into three classes from the point of view of their risk perceptions viz. risk seekers, 'risk averse and risk neutrals.
Utility theory aims at incorporation of decision maker's risk preference explicitly into the decision procedure. A rational decision maker would accept the investment project, which yields maximum' utility to him.
Utility at this stage may be defined as the satisfaction that an investor receives or obtains by employing funds in a particular way. Different investors have different sets of risk preferences and therefore in all likelihood would have received different utilities from identical proposal. Therefore, an investor having a desire to maximize his utility will not aim at maximizing the monetary values receivable from the proposal; rather he will aim at maximizing the utility receivable from the proposal.
The utility of money can be classified into three categories viz. Diminishing Marginal Utility., Constant Marginal Utility, and increasing marginal utility money. It is well established that individuals are .generally risk averters and demonstrate a decreasing marginal utility for money function. The reason for this is obvious. It means that each successive identical increment of money is worth less to him than the preceding one, although it is positive.
It requires identifying the utility function of investor. Utility function has to be design on the basis of investors risk preference and marginal utility of money for him. Project is accepted if, only if, it yield or maximize the utility for him.
The utility approach directly incorporates the risk preferences of the decision maker: However, its use in capital budgeting is not common. In practice, it is very difficult to specify a utility function. This problem become more severe, If the decision is to be taken by a group of persons, it is very difficult to derive a consistent utility function. Utility function estimated today may not hold good in future as the utility of money keeps on changing from time to time.