The purpose of this article is to clarify the usefulness of quadratic utility function in evaluating investment
projects. In the field of corporate finance, the standard technique used to evaluate proposed investment projects
is capital asset pricing model and its graphed security market line. According to CAPM, the market risk is the
risk to be quantified as risk premium in estimating the cost of equity capital. CAPM assumes that marginal and
important investors are well−diversified institutional investors like pension funds, insurance companies and
investment funds. To such investors, private risk of each project is negligible, because it is diversifiable.
However, many top management in Japan believes that other stakeholders like employee, commercial banks,
suppliers and etc are equally important. Their loyalty and contribution to the company is a vital factor to the
success of company. Their fate or success becomes dependent on the growth and viability of the company, as
they often commit their resource to the company for life or for a long period of time. In this case, Japanese top
management should try to maintain and strengthen their long−term sustainability, which is more important than
the short−term increase of shareholders wealth. In this context, evaluating proposed investment projects, private
as well as market risk should be included with equal importance in calculating the total risk.
In this article, I tried to compare such technique as SML (CAPM), Capital Market Line and quadratic utility
function and clarified their difference in their evaluation results. CML and quadratic utility function are useful in
evaluating private and total risk of investment projects, because their formula, different from other utility
functions, contain the standard deviation to represent investment risk. Quadratic utility function seems to be a
proper method in evaluating the investment project which involves unique or different type of business risk and
requires relatively huge amount of investment. Dealing with utility function, I demonstrated to quantify utility
value in terms of absolute amount of money rather than indicating the value in commonly used percentage. This
would enable us to compare with the other traditional technique of net present value.