Chapter 14

Risk and Managerial

Options in Capital
Budgeting
14-1

Risk and Managerial

Options in Capital Budgeting
The

Problem of Project Risk

Total

Project Risk

Contribution

to Total Firm Risk:

Firm-Portfolio Approach

Managerial
14-2

Options

An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
14-3

Probability
.05
.25
.40
.25
.05

Cash Flow
$ -3,000
1,000
5,000
9,000
13,000

Probability Distribution
of Year 1 Cash Flows
Proposal A

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

14-4

13,000

Expected Value of Year 1

Cash Flows (Proposal A)
CF1
$ -3,000
1,000
5,000
9,000
13,000
=1.00
14-5

P1

(CF1)(P1)

.05
$ -150
.25
250
.40
2,000
.25
2,250
.05
650
CF1=$5,000

Variance of Year 1
Cash Flows (Proposal A)

14-6

(CF1)(P1)

(CF1 - CF1)2(P1)

$ -150
250
2,000
2,250
650
$5,000

( -3,000 - 5,000)2 (.05)

( 1,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 9,000 - 5,000)2 (.25)
(13,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal A)

14-7

(CF1)(P1)

(CF1 - CF1)2*(P1)

$ -150
250
2,000
2,250
650
$5,000

3,200,000
4,000,000
0
4,000,000
3,200,000
14,400,000

Summary of Proposal A
The standard deviation =
SQRT (14,400,000) = $3,795
The expected cash flow = $5,000

14-8

An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
14-9

Probability
.05
.25
.40
.25
.05

Cash Flow
$ -1,000
2,000
5,000
8,000
11,000

Probability Distribution
of Year 1 Cash Flows
Proposal B

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

14-10

13,000

Expected Value of Year 1

Cash Flows (Proposal B)
CF1
$ -1,000
2,000
5,000
8,000
11,000
=1.00
14-11

P1

(CF1)(P1)

.05
$ -50
.25
500
.40
2,000
.25
2,000
.05
550
CF1=$5,000

Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$

-50
500
2,000
2,000
550
$5,000

14-12

(CF1 - CF1)2(P1)
( -1,000 - 5,000)2 (.05)
( 2,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 8,000 - 5,000)2 (.25)
(11,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$

-50
500
2,000
2,000
550
$5,000

14-13

(CF1 - CF1)2(P1)
1,800,000
2,250,000
0
2,250,000
1,800,000
8,100,000

Summary of Proposal B
The standard deviation
SQRT (8,100,000)

=
= $2,846

The expected cash flow = $5,000

The standard deviation of
Proposal B < Proposal A.
( $2,846 < $3,795 )
14-14

Projects have risk

that may change
from period to
period.
Projects are more
likely to have
continuous, rather
than discrete
distributions.

Cash Flow ($)

Total Project Risk

1
14-15

3
Year

Probability 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.
14-16

Probability Tree Approach

-$900

14-17

Basket Wonders is
examining a project that will
have an initial cost today of
$900.
$900 Uncertainty
surrounding the first year
cash flows creates three
possible cash-flow
scenarios in Year 1.
1

Probability Tree Approach

-$900

14-18

(.20) $1,200 1

Node 1: 20% chance of a

$1,200 cash-flow.

(.60)

$450

Node 2: 60% chance of a

$450 cash-flow.

(.20)

-$600 3

Year 1

Node 3: 20% chance of a

-$600 cash-flow.

Probability Tree Approach

(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-19

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2

Each node in
Year 2
represents a
branch of our
probability
tree.
The
probabilities
are said to be
conditional
probabilities.
probabilities

Joint Probabilities [P(1,2)]

(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-20

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 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

Project NPV Based on

Probability Tree Usage
z

The probability
tree accounts for
the distribution
of cash flows.
Therefore,
discount all cash
flows at only the
risk-free rate of
return.
14-21

NPV = i= 1 (NPVi)(Pi)
The NPV for branch i of
the probability tree for two
years of cash flows is

CF1
CF2
NPVi =
+
1
(1 + Rf ) (1 + Rf )2
- ICO

NPV for Each Cash-Flow

Stream at 5% Risk-Free Rate
(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-22

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2

$ 2,238.32
$ 1,331.29
$ 1,059.18
$

344.90

72.79

-$

199.32

-$ 1,017.91
-$ 1,562.13
-$ 2,106.35

NPV on the Calculator

Remember, we can use
the cash flow registry
to solve these NPV
problems quickly and
accurately!

14-23

Actual NPV Solution Using

Your Financial Calculator
Solving for Branch #3:

14-24

Step 1:
Press
Step 2:
Press
Step 3: For CF0 Press

CF
2nd
CLR Work
-900
Enter

Step 4:
Step 5:
Step 6:
Step 7:

1200
1
900
1

For C01 Press

For F01 Press
For C02 Press
For F02 Press

Enter
Enter
Enter
Enter

key
keys

keys

keys
keys
keys
keys

Actual NPV Solution Using

Your Financial Calculator
Solving for Branch #3:
Step 8:
Step 9:

Press
Press

Step 10: For I=, Enter

keys
key

NPV
5
CPT

Enter

keys

Step 11:

Press

key

Result:

Net Present Value = $1,059.18

You would complete this for EACH branch!

14-25

Calculating the Expected

Net Present Value (NPV)
Branch
Branch 1
Branch 2
Branch 3
Branch 4
Branch 5
Branch 6
Branch 7
Branch 8
Branch 9

NPVi
$ 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)
NPVi * 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 = -$ 17.01

14-26

Calculating the Variance

of the Net Present Value
NPVi
$ 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)
.02
.12
.06
.21
.24
.15
.02
.10
.08

(NPVi - NPV )2[P(1,2)]

P(1,2)
$ 101,730.27
$ 218,149.55
$ 69,491.09
$ 27,505.56
$ 1,935.37
$ 4,985.54
$ 20,036.02
$ 238,739.58
$ 349,227.33

Variance = $1,031,800.31
14-27

Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV

14-28

= -$

17.01

Simulation 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.
14-29

Simulation Approach
Factors we might consider in a model:

14-30

Market analysis
Market size, selling price, market
growth rate, and market
share
Investment cost analysis
Investment required, useful life of
facilities, and residual value
Operating and fixed costs
Operating costs and fixed costs

Simulation 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.
14-31

Simulation Approach

PROBABILITY
OF OCCURRENCE

Each proposal will generate an internal rate of

return.
return The process of generating many, many
simulations results in a large set of internal
rates of return. The distribution might look like
the following:

14-32

INTERNAL RATE OF RETURN (%)

Contribution to Total Firm Risk:

Firm-Portfolio Approach
Proposal B

Combination of
Proposals A and B

CASH FLOW

Proposal A

TIME

TIME

TIME

Combining projects in this manner reduces

the firm risk due to diversification.
diversification

14-33

Determining the Expected

NPV for a Portfolio of Projects
m

NPVP = ( NPVj )
j=1

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.
14-34

Determining Portfolio
Standard Deviation
P =

jk
j=1 k=1

jk is the covariance between possible

NPVs for projects j and k

jk = j k r jk .

j is the standard deviation of project j,

k is the standard deviation of project k,
14-35

rjk is the correlation coefficient between

projects j and k.

E: Existing Projects
8 Combinations
E

E+1
E+2
E+3

E+1+2
E+1+3
E+2+3

E+1+2+3
A, B, and C are
dominating combinations
from the eight possible.
14-36

Expected Value of NPV

Combinations of
Risky Investments
C
B
E
A
Standard Deviation

Managerial (Real) Options

Management flexibility to make
future decisions that affect a
projects expected cash flows, life,
or future acceptance.
Project Worth = NPV +
Option(s) Value
14-37

Managerial (Real) Options

Expand (or contract)

Allows the firm to expand (contract) production

if conditions become favorable (unfavorable).

Abandon

Allows the project to be terminated early.

Postpone

14-38

Allows the firm to delay undertaking a project

(reduces uncertainty via new information).

Previous Example with

Project Abandonment
(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-39

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900

(.25) $ 300

Assume that
this project
can be
abandoned at
the end of the
first year for
$200.
$200

(.10) $ 500
(.50) -$ 100
(.40) -$ 700

What is the
project
worth?
worth

(.35) $ 900
(.40) $ 600

Year 2

Project Abandonment
(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-40

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2

Node 3:
3
(500/1.05)(.1)+
500
(-100/1.05)(.5)+
-100
(-700/1.05)(.4)=
-700
($476.19)(.1)+
-($ 95.24)(.5)+
-($666.67)(.4)=
-($266.67)

Project Abandonment
(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

14-41

$450

-$600 3

Year 1

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600

The optimal
decision at the
end of Year 1 is
to abandon the
project for
$200.
$200

(.25) $ 300

$200 >

(.10) $ 500
(.50) -$ 100
(.40) -$ 700

-($266.67)

Year 2

What is the
new project
value?

Project Abandonment
(.20)
.20 $1,200 1

-$900

(.60)
60

(.20)
.20

$450

-$400* 3

(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(1.0) $

*-$600 + $200 abandonment

14-42

Year 1

Year 2

$ 2,238.32
$ 1,331.29
$ 1,059.18
$

344.90

72.79

-$

199.32

-$ 1,280.95

Summary of the Addition

of the Abandonment Option
The standard deviation* =
SQRT (740,326)
= $857.56
The expected NPV*
= $ 71.88
NPV* = Original NPV +
Abandonment Option
Thus, $71.88 = -$17.01 + Option
Abandonment Option
= $ 88.89
14-43

* For True Project considering abandonment option