Ch 14 - Risk and Managerial Options in Capital Budgeting
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Transcript of Ch 14 - Risk and Managerial Options in Capital Budgeting
14-1
Chapter 14Chapter 14
Risk and Managerial Risk and Managerial Options in Capital Options in Capital
BudgetingBudgeting
Risk and Managerial Risk and Managerial Options in Capital Options in Capital
BudgetingBudgeting© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
14-2
Risk and Managerial Risk and Managerial Options in Capital BudgetingOptions in Capital BudgetingRisk and Managerial Risk and Managerial Options in Capital BudgetingOptions in Capital Budgeting
The Problem of Project Risk
Total Project Risk
Contribution to Total Firm Risk: Firm-Portfolio Approach
Managerial Options
The Problem of Project Risk
Total Project Risk
Contribution to Total Firm Risk: Firm-Portfolio Approach
Managerial Options
14-3
An Illustration of Total An Illustration of Total Risk (Discrete Distribution)Risk (Discrete Distribution)An Illustration of Total An Illustration of Total Risk (Discrete Distribution)Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1PROPOSAL APROPOSAL A
State ProbabilityProbability Cash FlowCash Flow
Deep Recession .05 $ -3,000
Mild Recession .25 1,000
Normal .40 5,000
Minor Boom .25 9,000
Major Boom .05 13,000
ANNUAL CASH FLOWS: YEAR 1PROPOSAL APROPOSAL A
State ProbabilityProbability Cash FlowCash Flow
Deep Recession .05 $ -3,000
Mild Recession .25 1,000
Normal .40 5,000
Minor Boom .25 9,000
Major Boom .05 13,000
14-4
Probability Distribution Probability Distribution of Year 1 Cash Flowsof Year 1 Cash FlowsProbability Distribution Probability Distribution of Year 1 Cash Flowsof Year 1 Cash Flows
.40
.05
.25
Pro
bab
ility
-3,000 1,000 5,000 9,000 13,000
Cash Flow ($)
Proposal AProposal A
14-5
CFCF11 PP11 (CFCF11)()(PP11))
$ -3,000 .05 $ -150 1,000 .25 250 5,000 .40 2,000 9,000 .25 2,250 13,000 .05 650
=1.001.00 CFCF11=$5,000$5,000
CFCF11 PP11 (CFCF11)()(PP11))
$ -3,000 .05 $ -150 1,000 .25 250 5,000 .40 2,000 9,000 .25 2,250 13,000 .05 650
=1.001.00 CFCF11=$5,000$5,000
Expected Value of Year 1 Expected Value of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))Expected Value of Year 1 Expected Value of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))
14-6
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22((PP11) )
$ -150 ( -3,000 - 5,000)22 ( (.05.05)) 250 ( 1,000 - 5,000)22 ( (.25.25)) 2,000 ( 5,000 - 5,000)22 ( (.40.40)) 2,250 ( 9,000 - 5,000)22 ( (.25.25)) 650 (13,000 - 5,000)22 ( (.05.05))
$5,000$5,000
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22((PP11) )
$ -150 ( -3,000 - 5,000)22 ( (.05.05)) 250 ( 1,000 - 5,000)22 ( (.25.25)) 2,000 ( 5,000 - 5,000)22 ( (.40.40)) 2,250 ( 9,000 - 5,000)22 ( (.25.25)) 650 (13,000 - 5,000)22 ( (.05.05))
$5,000$5,000
Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))
14-7
Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal AProposal A))
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22*(*(PP11) )
$ -150 3,200,000 250 4,000,000 2,000 0 2,250 4,000,000 650 3,200,000
$5,000$5,000 14,400,00014,400,000
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22*(*(PP11) )
$ -150 3,200,000 250 4,000,000 2,000 0 2,250 4,000,000 650 3,200,000
$5,000$5,000 14,400,00014,400,000
14-8
Summary of Summary of Proposal AProposal A
The standard deviation standard deviation = SQRT (14,400,000) = $3,795$3,795
The expected cash flow expected cash flow = $5,000$5,000
14-9
An Illustration of Total An Illustration of Total Risk (Discrete Distribution)Risk (Discrete Distribution)An Illustration of Total An Illustration of Total Risk (Discrete Distribution)Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1PROPOSAL BPROPOSAL B
State ProbabilityProbability Cash FlowCash Flow
Deep Recession .05 $ -1,000
Mild Recession .25 2,000
Normal .40 5,000
Minor Boom .25 8,000
Major Boom .05 11,000
ANNUAL CASH FLOWS: YEAR 1PROPOSAL BPROPOSAL B
State ProbabilityProbability Cash FlowCash Flow
Deep Recession .05 $ -1,000
Mild Recession .25 2,000
Normal .40 5,000
Minor Boom .25 8,000
Major Boom .05 11,000
14-10
Probability Distribution Probability Distribution of Year 1 Cash Flowsof Year 1 Cash FlowsProbability Distribution Probability Distribution of Year 1 Cash Flowsof Year 1 Cash Flows
.40
.05
.25
Pro
bab
ility
-3,000 1,000 5,000 9,000 13,000
Cash Flow ($)
Proposal BProposal B
14-11
Expected Value of Year 1 Expected Value of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))Expected Value of Year 1 Expected Value of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))
CFCF11 PP11 (CFCF11)()(PP11))
$ -1,000 .05 $ -50 2,000 .25 500 5,000 .40 2,000 8,000 .25 2,000 11,000 .05 550
=1.001.00 CFCF11=$5,000$5,000
CFCF11 PP11 (CFCF11)()(PP11))
$ -1,000 .05 $ -50 2,000 .25 500 5,000 .40 2,000 8,000 .25 2,000 11,000 .05 550
=1.001.00 CFCF11=$5,000$5,000
14-12
(CFCF11)()(PP11)) ((CFCF11 - - CFCF11))22((PP11))
$ -50 ( -1,000 - 5,000)22 ( (.05.05)) 500 ( 2,000 - 5,000)22 ( (.25.25)) 2,000 ( 5,000 - 5,000)22 ( (.40.40)) 2,000 ( 8,000 - 5,000)22 ( (.25.25)) 550 (11,000 - 5,000)22 ( (.05.05))
$5,000$5,000
(CFCF11)()(PP11)) ((CFCF11 - - CFCF11))22((PP11))
$ -50 ( -1,000 - 5,000)22 ( (.05.05)) 500 ( 2,000 - 5,000)22 ( (.25.25)) 2,000 ( 5,000 - 5,000)22 ( (.40.40)) 2,000 ( 8,000 - 5,000)22 ( (.25.25)) 550 (11,000 - 5,000)22 ( (.05.05))
$5,000$5,000
Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))
14-13
Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))Variance of Year 1 Variance of Year 1 Cash Flows (Cash Flows (Proposal BProposal B))
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22((PP11))
$ -50 1,800,000 500 2,250,000 2,000 0 2,000 2,250,000 550 1,800,000
$5,000$5,000 8,100,000 8,100,000
(CFCF11)()(PP11)) ( (CFCF11 - - CFCF11))22((PP11))
$ -50 1,800,000 500 2,250,000 2,000 0 2,000 2,250,000 550 1,800,000
$5,000$5,000 8,100,000 8,100,000
14-14
Summary of Summary of Proposal BProposal B
The standard deviation of Proposal B Proposal B < < Proposal AProposal A..
( ( $2,846$2,846 < < $3,795$3,795 ) )
The standard deviation standard deviation = SQRT (8,100,000) = $2,846$2,846
The expected cash flow expected cash flow = $5,000$5,000
14-15
Total Project RiskTotal Project Risk
Projects have risk that may change
from period to period.
Projects are more likely to have
continuous, rather than discrete distributions.
Cas
h F
low
($)
11 22 33 Year
14-16
Probability Tree ApproachProbability Tree Approach
A graphic or tabular approach for organizing the possible cash-flow
streams generated by an investment. The presentation
resembles the branches of a tree. Each complete branch represents one possible cash-flow sequence.
14-17
Probability Tree ApproachProbability Tree Approach
Basket Wonders is examining a project that will have an initial cost initial cost today of
$900$900. Uncertainty surrounding the first year cash flows creates three
possible cash-flow scenarios in Year 1Year 1.
-$900-$900
14-18
Probability Tree ApproachProbability Tree Approach
Node 1: 20% chance of a $1,200$1,200 cash-flow.
Node 2: 60% chance of a $450$450 cash-flow.
Node 3: 20% chance of a -$600-$600 cash-flow.
-$900-$900
(.20) $1,200$1,200
(.20) -$600-$600
(.60) $450$450
Year 1Year 1
11
22
33
14-19
Probability Tree ApproachProbability Tree Approach
Each node in Year 2 Year 2
represents a branchbranch of our
probability tree.
The probabilities are said to be
conditional conditional probabilitiesprobabilities.
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300 $ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) -$ 700-$ 700
Year 2Year 2
14-20
Joint Probabilities [P(1,2)]Joint Probabilities [P(1,2)]
.02 Branch 1
.12 Branch 2
.06 Branch 3
.21 Branch 4
.24 Branch 5
.15 Branch 6
.02 Branch 7
.10 Branch 8
.08 Branch 9
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300$ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) -$ 700-$ 700
Year 2Year 2
14-21
Project NPV Based on Project NPV Based on Probability Tree UsageProbability Tree Usage
The probability tree accounts for the distribution of cash flows.
Therefore, discount all cash flows at only the risk-freerisk-free rate of
return.
The NPV for branch i NPV for branch i of the probability tree for two
years of cash flows is
NPV = (NPVNPVii)(PPii)
NPVNPVii = CFCF11
(1 + RRff )11 (1 + RRff )22
CFCF22
- ICOICO
+
i = 1
z
14-22
NPV for Each Cash-Flow NPV for Each Cash-Flow Stream at 5% Risk-Free RateStream at 5% Risk-Free Rate
$ 2,238.32
$ 1,331.29
$ 1,059.18
$ 344.90
$ 72.79
-$ 199.32
-$ 1,017.91
-$ 1,562.13
-$ 2,106.35
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300 $ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) -$ 700-$ 700
Year 2Year 2
14-23
NPV on the CalculatorNPV on the Calculator
Remember, we can use the cash flow registry
to solve these NPV problems quickly and
accurately!
14-24
Actual NPV Solution Using Actual NPV Solution Using Your Financial CalculatorYour Financial CalculatorActual NPV Solution Using Actual NPV Solution Using Your Financial CalculatorYour Financial Calculator
Solving for Branch #3:Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
Step 3: For CF0 Press -900 Enter keys
Step 4: For C01 Press 1200 Enter keys
Step 5: For F01 Press 1 Enter keys
Step 6: For C02 Press 900 Enter keys
Step 7: For F02 Press 1 Enter keys
14-25
Actual NPV Solution Using Actual NPV Solution Using Your Financial CalculatorYour Financial CalculatorActual NPV Solution Using Actual NPV Solution Using Your Financial CalculatorYour Financial Calculator
Solving for Branch #3:
Step 8: Press keys
Step 9: Press NPV key
Step 10: For I=, Enter 5 Enter keys
Step 11: Press CPT key
Result: Net Present Value = $1,059.18
You would complete this for EACH branch!
14-26
Calculating the Expected Calculating the Expected Net Present Value (Net Present Value (NPVNPV))
Branch NPV NPVii
Branch 1 $ 2,238.32Branch 2 $ 1,331.29Branch 3 $ 1,059.18Branch 4 $ 344.90Branch 5 $ 72.79Branch 6 -$ 199.32Branch 7 -$ 1,017.91Branch 8 -$ 1,562.13Branch 9 -$ 2,106.35
P(1,2) P(1,2) NPVNPVii * P(1,2) P(1,2)
.02 $ 44.77 .12 $159.75 .06 $ 63.55 .21 $ 72.43 .24 $ 17.47 .15 -$ 29.90 .02 -$ 20.36 .10 -$156.21 .08 -$168.51
Expected Net Present Value Expected Net Present Value = -$ 17.01-$ 17.01
14-27
Calculating the Variance Calculating the Variance of the Net Present Valueof the Net Present Value
NPVNPVii
$ 2,238.32 $ 1,331.29 $ 1,059.18 $ 344.90 $ 72.79-$ 199.32-$ 1,017.91-$ 1,562.13-$ 2,106.35
P(1,2) P(1,2) ((NPVNPVii - NPVNPV )2[P(1,2)P(1,2)]
.02 $ 101,730.27 .12 $ 218,149.55 .06 $ 69,491.09 .21 $ 27,505.56 .24 $ 1,935.37 .15 $ 4,985.54 .02 $ 20,036.02 .10 $ 238,739.58 .08 $ 349,227.33
Variance Variance = $1,031,800.31$1,031,800.31
14-28
Summary of the Summary of the Decision Tree AnalysisDecision Tree Analysis
The standard deviation standard deviation = SQRT ($1,031,800) = $1,015.78$1,015.78
The expected NPV expected NPV = -$ 17.01-$ 17.01
14-29
Simulation ApproachSimulation Approach
An approach that allows us to test the possible results of an
investment proposal before it is accepted. Testing is based on a model coupled with probabilistic
information.
14-30
Simulation ApproachSimulation Approach
Market analysisMarket analysis Market size, selling price, market
growth rate, and market share
Investment cost analysisInvestment cost analysis Investment required, useful life of
facilities, and residual value Operating and fixed costsOperating and fixed costs
Operating costs and fixed costs
Factors we might consider in a model:
14-31
Simulation ApproachSimulation Approach
Each variable is assigned an appropriate probability distribution. The distribution for
the selling price of baskets created by Basket Wonders might look like:
$20 $25 $30 $35 $40 $45 $50.02 .08 .22 .36 .22 .08 .02
The resulting proposal value is dependent on the distribution and interaction of EVERY variable listed on slide 14-30.
14-32
Simulation ApproachSimulation Approach
Each proposal will generate an internal rate of internal rate of returnreturn. The process of generating many, many
simulations results in a large set of internal rates of return. The distributiondistribution might look like
the following:
INTERNAL RATE OF RETURN (%)
PR
OB
AB
ILIT
YO
F O
CC
UR
RE
NC
E
14-33
Combining projects in this manner reduces the firm risk due to diversificationdiversification.
Combining projects in this manner reduces the firm risk due to diversificationdiversification.
Contribution to Total Firm Risk: Contribution to Total Firm Risk: Firm-Portfolio ApproachFirm-Portfolio ApproachContribution to Total Firm Risk: Contribution to Total Firm Risk: Firm-Portfolio ApproachFirm-Portfolio Approach
CA
SH
FL
OW
TIME TIMETIME
Proposal AProposal A Proposal BProposal BCombination of Combination of
Proposals Proposals AA andand BB
14-34
NPVP = ( NPVj )
NPVP is the expected portfolio NPV,
NPVj is the expected NPV of the jth NPV that the firm undertakes,
m is the total number of projects in the firm portfolio.
NPVP = ( NPVj )
NPVP is the expected portfolio NPV,
NPVj is the expected NPV of the jth NPV that the firm undertakes,
m is the total number of projects in the firm portfolio.
Determining the Expected Determining the Expected NPV for a Portfolio of ProjectsNPV for a Portfolio of ProjectsDetermining the Expected Determining the Expected NPV for a Portfolio of ProjectsNPV for a Portfolio of Projects
m
j=1
14-35
PP = jk
jk is the covariance between possible
NPVs for projects j and k
jk = j k rrjk .
j is the standard deviation of project j,
k is the standard deviation of project k,
rjk is the correlation coefficient between projects j and k.
PP = jk
jk is the covariance between possible
NPVs for projects j and k
jk = j k rrjk .
j is the standard deviation of project j,
k is the standard deviation of project k,
rjk is the correlation coefficient between projects j and k.
Determining Portfolio Determining Portfolio Standard DeviationStandard DeviationDetermining Portfolio Determining Portfolio Standard DeviationStandard Deviation
m
j=1
m
k=1
14-36
E: Existing ProjectsE: Existing Projects
8 Combinations
EE EE + 1 EE + 1 + 2 EE + 2 EE + 1 + 3EE + 3 EE + 2 + 3
EE + 1 + 2 + 3
AA, BB, and CC are dominatingdominating combinations from the eight possible.
Combinations of Combinations of Risky InvestmentsRisky Investments
A
B
C
E
Standard Deviation
Exp
ecte
d V
alu
e o
f N
PV
14-37
Managerial (Real) OptionsManagerial (Real) Options
Management flexibility to make future decisions that affect a
project’s expected cash flows, life, or future acceptance.
Project Worth = NPV + Option(s) Value
14-38
Managerial (Real) OptionsManagerial (Real) Options
Expand (or contract)Expand (or contract)
Allows the firm to expand (contract) production if conditions become favorable (unfavorable).
AbandonAbandon
Allows the project to be terminated early.
PostponePostpone
Allows the firm to delay undertaking a project (reduces uncertainty via new information).
14-39
Previous Example with Previous Example with Project AbandonmentProject Abandonment
Assume that this project
can be abandoned at the end of the first year for
$200$200.
What is the project project worthworth?
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300$ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) -$ 700-$ 700
Year 2Year 2
14-40
Project AbandonmentProject Abandonment
Node 3Node 3:
(500500/1.05)(.1)+ (-100-100/1.05)(.5)+ (-700-700/1.05)(.4)=
($476.19)(.1)+ -($ 95.24)(.5)+ -($666.67)(.4)=
-($266.67)-($266.67)
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300 $ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) --$ 700$ 700
Year 2Year 2
14-41
Project AbandonmentProject Abandonment
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$600-$600
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300 $ 300
(.10) $ 500$ 500
(.50) -$ 100-$ 100
(.40) -$ 700-$ 700
Year 2Year 2
The optimal decision at the end of Year 1 Year 1 is to abandon the project for
$200$200.
$200$200 >
-($266.67)-($266.67)
What is the “new” “new” project
value?
14-42
Project AbandonmentProject Abandonment
$ 2,238.32
$ 1,331.29
$ 1,059.18
$ 344.90
$ 72.79
-$ 199.32
-$ 1,280.95
-$900-$900
(.20.20) $1,200$1,200
(.20.20) -$400*-$400*
(.6060) $450$450
Year 1Year 1
11
22
33
(.60) $1,200$1,200
(.30) $ 900$ 900
(.10) $2,200$2,200
(.35) $ 900$ 900
(.40) $ 600$ 600
(.25) $ 300$ 300
(1.0) $ 0 $ 0
Year 2Year 2
*-$600 + $200 abandonment
14-43
Summary of the Addition Summary of the Addition of the Abandonment Optionof the Abandonment Option
* For “True” Project considering abandonment option
The standard deviation*standard deviation* = SQRT (740,326) = $857.56$857.56
The expectedexpected NPV*NPV* = $$ 71.8871.88
NPV* NPV* = Original NPV + Abandonment OptionAbandonment Option
Thus,Thus, $71.88 $71.88 = -$17.01 + OptionOption
Abandonment Option Abandonment Option = $ 88.89$ 88.89