FIN 412: THEORY OF

CORPORATE FINANCE
UTILITY THEORY

LECTURER: Prof. R. A. Olowe

 COURSE RESOURCES
• The lecture is based on the recommended text for the course
• Main reading:

• Olowe, R. A. (2017). Financial Management: Concepts, Financial

System and Business Finance. 4th edition. Lagos: Brierly Jones (ORA)
• Copeland T., and Weston J. (1983). Financial Theory and Corporate
Policy. Latest edition. (CTW)
• Brealey/ Myers. Principles of Corporate Finance.10th Edition (or
earlier). (BM)
• Frantz/Payne/Favilukis. Study Guide. Corporate Finance. First Edition.
2011. (FPF)

Olowe R. A. 2021
 COURSE RESOURCES
• Supplementary reading:

• Ross S., R.Westerfield, J.Jaffe. (1999). Corporate Finance. Fifth Edition. IRWIN-McGraw-
Hill.
• Damodaran A. (1999). Applied Corporate Finance. Wiley&Sons.
• Daniel, K., & Marshall, D. (1997). The equity premium puzzle and the risk-free rate puzzle
at long horizons'. Macroeconomic Dynamics l, 452-484.
• DeBondt, W., & Thaler, R. (1985). Does the Stock Market Overreact?, Journal of Finance,
40, 793-805.
• Dimson, E., & Mussavian, M. (2000). Market Efficiency, The Current State of Business
Disciplines, vol.3, Spellbound Publications, 2000, pp 959-970
• Fama, E.F. (1998). Market Efficiency, Long-Term Returns, and Behavioral Finance. Journal
of Finance, 49(3) 283-306.
• Fama, E. F., & French, K. (1992).The Cross-Section of Expected Returns, Journal of
Finance, 47, 427- 465.
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• Fama, E. F. (1970). Efficient Capital markets: A Review of Theory and Empirical Work,
Journal of Finance, 25 (2), 383-417.
 CONTENT
• Overview
• Axioms or Assumptions of Utility Theory
• Utility Function - Properties
• Utility Functions
• Utility Function and Risk Aversion
• Measures of Risk Aversion
• Summary
• Review Questions

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 Overview
(CTW– Chap. 3)
• Every individual or investor make choices everyday
• Many times, the choices are among risky alternatives, thus, uncertain
• Utility theory is the theory of choice by individuals when faced with
uncertainty.
• The individual make choices among risky alternatives in such a way as
to obtain maximum satisfaction

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 Axioms or Assumptions of Utility Theory
(CWT Chap. 3)
• To develop utility theory, it is necessary to make assumptions about
individual behaviour also called axioms of cardinal utility (CWT, Chap.
3).

• Axiom 1: Comparability
If we have an entire set say , S of uncertain alternatives, an individual
can either prefer outcome x to outcome y i.e. (x⊱y) or y is preferred to
x (y⊱x) or the individual is indifferent as to x and y (x~ y).

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 Axioms or Assumptions of Utility Theory
(CWT Chap. 3)
• Axiom 2:Transitivity (also called called consistency).
• If x~ y and y ~ z, then x ~ z

• Axiom 3: Strong indepedence

Suppose we set up a gamble such that an individual has a probability α
of receiving outcome x and a probability 1- α of receiving outcome z.
This is denoted by G(x,z:α)
If x ~ y, then G(x,z:α) ~ G(y,z:α).

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 Axioms or Assumptions of Utility Theory
(CWT Chap. 3)
Axiom 4: Measurability
If x ⊱y ≽z or x ≽y ⊱z then there exist a unique α, such that
y ~ G(x,z:α).

Axiom 5: Ranking.
If y and u lies between x and z , i.e.
If x ≽ y ≽ z and x ≽ y ≽ z,
then following Axiom 4 we can establish gambles such that
y ~ G(x,z:α) and u ~ G(x,z:α2),
it follows that
if α, > α2, then y ⊱u, or if α1 = α2, then y ~ u.
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 Extension and Implication of the Assumptions
(CWT Chap. 3)
• If we add another assumption that all investors always prefer more
wealth to less, given the five axioms of utility theory discussed
previously, then we can say that investors will always seek to
maximize their expected utility of wealth.
• The maximization of expected utility of wealth is what is referred to
as the theory of choice
• All investors will calculate the expected utility of wealth for all
possible alternative choices and then choose the outcome that
maximizes their expected utility of wealth.

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 Utility Function - Properties
• Given the Gamble between x and z in Axiom 3 , G(x, z:α) we can write
expected wealth from the gamble as:
E(w) = α G(x) + (1- α)G(z)
For n gamble case:
n
E(w)   G(x i ) Pr ob.(x i )
i 1

• Utility function is order preserving, that is, if Utility of x (Ux) is greater

than utility of y (Uy), then x⊱y
• Expected utility can be used to rank combinations of risk alternatives
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 Utility Function - Properties
• In a two gamble case between x and z as shown previously
• E[U(w)] = αU(x) + (1- α)U(z)
• For n gamble case

E  U(x i )    U(x i ) Pr ob.(x i )

• Another important property of cardinal utility functions is increasing or

decreasing marginal utility.
• The measure of utility is called utiles
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 Utility Function
• Given the measure of utility in utiles, utility from various gambles or
level of wealth can be compiled in a tabular format and plotted in
form of a graph with wealth (w) on the horizontal axis and utility of
wealth U(w) on the vertical axis.
• Whatever shape we obtain is our Utility functions
• Utility function can take various shapes as:
• U(w) = a + bw (linear function)
• U(w) = a + bw +cw2 (quadratic function)
• U(w) = a + bw + cw2 +dw3 (quadratic function)
• U (w) = lnw (logarithm function)
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 Utility Function and Risk Aversion
• The shape of an individual utility function will enable us to assess
his/her attitude to risk
• Given the assumption that the individual prefer more wealth to less,
that is, marginal utility of wealth is positive, there are attitudes to
risk:
• Risk lover, risk neutral and risk averse

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 Utility Function and Risk Aversion
Figure 1: Utility Function showing three attitudes to risk: (a) risk lover, (b) risk neutral, (c) risk averse
Source: CWT, Chap. 3

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 Utility Function and Risk Aversion
• From Figure 1: The utility function of risk averse is strictly concave, while risk
neutral and risk lover is convex.
• Example 1
Olu, with an initial wealth of N20,000 is faced with gamble that has a 60%
chance of winning N10,000 and 40% chance of winning N500. Olu has a
logarithm utility function. What is his attitude to risk.
• Solution
• With the gamble:
• E(w) = N30,000(0.6) + N20,500(0.4) = N26,200
• Given the logarithm Utility function, U(w) = lnw
• U[E(w)]=U(N26,200) = 10.17 utiles
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 Utility Function and Risk Aversion
• E[U(w)] = 0.6[U(N30,000)] + 0.4[U(N20,500)] = 10.16 utiles
• Since U[E(w)] > E[U(w)], the individual is risk averse
• Generally if:
• U[E(w)] > E[U(w)] it indicates risk averse
• U[E(w)] = E[U(w)] it indicates risk neutral
• U[E(w)] < E[U(w)] it indicates risk lover

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 Utility Function and Risk Aversion
Risk Premium
• From Example 1, it is possible to calculate the maximum amount of
wealth an individual would be willing
to pay in order to avoid the gamble.
• This is called risk premium
• Risk premium = Expected Wealth – Certainty Equivalent wealth
(CEW)
• CEW is the level of wealth that individual would accept with certainty
if the gamble were removed,
• Cost of the Gamble = Current wealth - CEW

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 Utility Function and Risk Aversion
Risk Premium
• Thus, For Example 1, E[U(w)] =10.16 utiles
• CEW = w = e10.16 = N25,848.30
• Risk premium = N26,200 - N25,848.30 = N351.70
• Cost of the Gamble = N20,000 – N25848.3 = -N5,848.3

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 Measures of Risk Aversion
• Pratt [1964] and Arrow [1971] provide a specific definition of risk
aversion.
• If for instance, we have an individual with a current wealth of W
presented with an actuarially neutral gamble of Z naira (by actuarially
neutral we mean that E(Z) = 0).
• The question is to determine the risk premium, π(W, Z), that must be
added to the gamble to make the individual indifferent between it and
the actuarial value of the gamble

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 Measures of Risk Aversion
• Mathematically,
• E[(U(w+z)] – U[E(w+z)] = π(W, Z)
• E[(U(w+z)] = U[E(w+z)] + π(W, Z)

• Using Taylor’s series expansion, Pratt-Arrow of local risk premium, π,

is defined as:
 U(w) 
   
1 2

2

z
U (w) 

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 Measures of Risk Aversion
• The sign of the risk premium is determined by the items in bracket as
½σ2Zis always positive.
• This gives rise two measures of risk aversion – Absolute Risk Aversion
(ARA) and relative risk aversion (RRA)
U(w)
ARA  
U(w)

ARA measures risk aversion for a given level of wealth

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 Measures of Risk Aversion
U(w)
RRA   w
U(w)
• If an individual has a constant relative risk aversion (RRA), it implies
that he/she will have constant risk aversion to a proportional loss of
wealth even though the absolute loss increases as wealth does.
• Example 2
• Let us now calculate the ARA and RRA for our Example 1

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Measures of Risk Aversion
• U(w) = lnw
1
U(w) 
w
1
U(w)  
w2
 1
w2 1 1
ARA    
1
w w 20, 000

• RRA = w x ARA = w x1/w = 1

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 SUMMARY
• Utility theory is the theory of choice by individuals when faced with
uncertainty.
• To develop utility theory, it is necessary to make assumptions about
individual behaviour also called axioms of cardinal utility
• Rational individuals will always maximize the expected utility of
wealth

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 Review Question
• Try to Answer
• Suppose an individual with a logarithm utility function , U(w) = lnw
and an initial wealth of N5m is exposed to a situation that results in a
50/50 chance of winning or losing N1,000,000. If the individual can
buy insurance that completely removes the risk for a fee of N125,000
should he buy it or take the gamble?

Olowe R. A. 2021