Fundamentals of Financial Management, 12/e

Chapter 14: Risk and Managerial Options in Capital Budgeting

After studying Chapter 14,

Chapter 14 you should be able to:
Define the "riskiness" of a capital investment project.
Understand how cash-flow riskiness for a particular
Risk
Risk and
and Managerial
Managerial period is measured, including the concepts of
expected value, standard deviation, and coefficient of
variation.
(Real)
(Real) Options
Options in
in Describe methods for assessing total project risk,
including a probability approach and a simulation
approach.
Capital
Capital Budgeting
Budgeting Judge projects with respect to their contribution to
total firm risk (a firm-portfolio approach).
Pearson Education Limited 2004
Understand how the presence of managerial (real)
Fundamentals of Financial Management, 12/e
options enhances the worth of an investment project.
Created by: Gregory A. Kuhlemeyer, Ph.D. List, discuss, and value different types of managerial
14-1
Carroll College, Waukesha, WI
14-2
(real) options.

Risk and Managerial (Real) An Illustration of Total

Options in Capital Budgeting Risk (Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
The Problem of Project Risk
PROPOSAL A
Total Project Risk State Probability Cash Flow

Contribution to Total Firm Risk: Deep Recession .05 $ -3,000

Mild Recession .25 1,000
Firm-Portfolio Approach
Normal .40 5,000
Managerial (Real) Options Minor Boom .25 9,000
Major Boom .05 13,000
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Probability Distribution Expected Value of Year 1

of Year 1 Cash Flows Cash Flows ((Proposal
Proposal A
A))
Proposal A
Probability .40 CF1 P1 ((CF
CF1)(P
)(P1)
$ -3,000 .05 $ -150
.25
1,000 .25 250
5,000 .40 2,000
.05 9,000 .25 2,250
-3,000 1,000 5,000 9,000 13,000
13,000 .05 650
Cash Flow ($) =1.00
=1.00 CF1=
=$5,000
$5,000
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Variance of Year 1 Variance of Year 1

Cash Flows ((Proposal
Proposal A
A)) Cash Flows ((Proposal
Proposal A
A))
((CF
CF1)(P
)(P1) (CF1 - CF1)2(P
(CF (P1) ((CF
CF1)(P
)(P1) (CF1 - CF1)2*(P
(CF *(P1)
$ -150 ( -3,000 - 5,000)2 (.05)
(.05) $ -150 3,200,000
250 ( 1,000 - 5,000)2 (.25)
(.25) 250 4,000,000
2,000 2
( 5,000 - 5,000) (.40)
(.40) 2,000 0
2,250 ( 9,000 - 5,000)2 (.25)
(.25) 2,250 4,000,000
650 2
(13,000 - 5,000) (.05)
(.05) 650 3,200,000
$5,000 $5,000 14,400,000
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

An Illustration of Total
Summary of Proposal A Risk (Discrete Distribution)
The standard deviation = SQRT (14,400,000) ANNUAL CASH FLOWS: YEAR 1
= $3,795 PROPOSAL B
The expected cash flow State Probability Cash Flow
= $5,000
Deep Recession .05 $ -1,000
Coefficient of Variation (CV) = $3,795 / $5,000
Mild Recession .25 2,000
= 0.759
Normal .40 5,000
CV is a measure of relative risk and is the ratio of Minor Boom .25 8,000
standard deviation to the mean of the distribution. Major Boom .05 11,000
14-9 14-10

Probability Distribution Expected Value of Year 1

of Year 1 Cash Flows Cash Flows ((Proposal
Proposal B
B))
Proposal B
.40 CF1 P1 ((CF
CF1)(P
)(P1)
Probability

$ -1,000 .05 $ -50

.25
2,000 .25 500
5,000 .40 2,000
.05 8,000 .25 2,000
-3,000 1,000 5,000 9,000 13,000
11,000 .05 550
Cash Flow ($) =1.00
=1.00 CF1=
=$5,000
$5,000
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Variance of Year 1 Variance of Year 1

Cash Flows ((Proposal
Proposal B
B)) Cash Flows ((Proposal
Proposal B
B))
((CF
CF1)(P
)(P1) (CF1 - CF1)2(P
(CF (P1) ((CF
CF1)(P
)(P1) (CF1 - CF1)2(P
(CF (P1)
$ -50 ( -1,000 - 5,000)2 (.05)
(.05) $ -50 1,800,000
500 ( 2,000 - 5,000)2 (.25)
(.25) 500 2,250,000
2,000 2
( 5,000 - 5,000) (.40)
(.40) 2,000 0
2,000 ( 8,000 - 5,000)2 (.25)
(.25) 2,000 2,250,000
550 2
(11,000 - 5,000) (.05)
(.05) 550 1,800,000
$5,000 $5,000 8,100,000
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Summary of Proposal B Total Project Risk

The standard deviation = SQRT (8,100,000)
Projects have risk
= $2,846 that may change
The expected cash flow = $5,000 from period to

Cash Flow ($)

Coefficient of Variation (CV) = $2,846 / $5,000 period.
= 0.569 Projects are more
likely to have
The standard deviation of B < A ($2,846<
$2,846< $3,795),
$3,795), so B
is less risky than A.
continuous, rather
than discrete
The coefficient of variation of B < A (0.569
(0.569<
<0.759),
0.759), so B distributions.
has less relative risk than A.
1 2 3
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Probability Tree Approach Probability Tree Approach

A graphic or tabular approach for Basket Wonders is

organizing the possible cash-flow examining a project that will
streams generated by an have an initial cost today of
investment. The presentation -$900 $900.
$900 Uncertainty
resembles the branches of a tree. surrounding the first year
Each complete branch represents cash flows creates three
one possible cash-flow sequence. possible cash-flow
scenarios in Year 1.
1
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Probability Tree Approach Probability Tree Approach

(.10) $2,200
Each node in
(.20) $1,200 1 Node 1: 20% chance of a (.20
.20) $1,200 1 (.60) $1,200 Year 2
$1,200 cash-flow. (.30) $ 900 represents a
branch of our
(.35) $ 900 probability
(.60) $450 Node 2: 60% chance of a (.60
60) $450 (.40) $ 600 tree.
-$900 2 -$900 2
$450 cash-flow. (.25) $ 300
The
(.10) $ 500 probabilities
(.20) -$600 3 Node 3: 20% chance of a (.20
.20) -$600 3 (.50) -$ 100 are said to be
-$600 cash-flow. (.40) -$ 700 conditional
probabilities.
probabilities
Year 1 Year 1 Year 2
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Pearson Education Limited 2004 Carroll College, Waukesha, WI
 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Project NPV Based on

Joint Probabilities [P(1,2)] Probability Tree Usage
(.10) $2,200
.02 Branch 1 z
(.20
.20) $1,200 1 (.60) $1,200
.12 Branch 2 The probability NPV = i= 1 (NPVi)(Pi)
(.30) $ 900 tree accounts for
.06 Branch 3
(.35) $ 900 the distribution
.21 Branch 4 The NPV for branch i of
(.60
60) $450 (.40) $ 600 of cash flows.
-$900 2 .24 Branch 5 the probability tree for two
(.25) $ 300 Therefore,
.15 Branch 6 discount all cash years of cash flows is
(.10) $ 500
.02 Branch 7 flows at only the CF1 CF2
(.20
.20) -$600 3 (.50) -$ 100 NPVi =
.10 Branch 8 risk-
risk-free rate of +
(.40) -$ 700 (1 + Rf ) (1 + Rf )2
1
.08 Branch 9 return.
Year 1 Year 2
- ICO
14-21 14-22

NPV for Each Cash-Flow

Stream at 5% Risk-Free Rate NPV on the Calculator
(.10) $2,200
$ 2,238.32
(.20
.20) $1,200 1 (.60) $1,200 Remember, we can
$ 1,331.29
(.30) $ 900
$ 1,059.18 use the cash flow
(.35) $ 900
registry to solve
$ 344.90 these NPV problems
(.60
60) $450 (.40) $ 600
-$900 2 $ 72.79 quickly and
(.25) $ 300 accurately!
-$ 199.32
(.10) $ 500
-$ 1,017.91
(.20
.20) -$600 3 (.50) -$ 100
-$ 1,562.13
(.40) -$ 700
-$ 2,106.35
Year 1 Year 2
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Pearson Education Limited 2004 Carroll College, Waukesha, WI
 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Actual NPV Solution Using Actual NPV Solution Using

Your Financial Calculator Your Financial Calculator
Solving for Branch #3:
Solving for Branch #3: Step 8: Press keys
Step 1: Press CF key Step 9: Press NPV key
Step 2: Press 2nd CLR Work keys Step 10: For I=, Enter 5 Enter keys
Step 3: For CF0 Press -900 Enter keys
Step 11: Press CPT key
Step 4: For C01 Press 1200 Enter keys
Step 5: For F01 Press 1 Enter keys
Result: Net Present Value = $1,059.18
Step 6: For C02 Press 900 Enter keys
Step 7: For F02 Press 1 Enter keys
You would complete this for EACH branch!

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Calculating the Expected Calculating the Variance

Net Present Value (NPV) of the Net Present Value
Branch NPVi P(1,2) NPVi * P(1,2) NPVi P(1,2) (NPVi - NPV )2[P(1,2)
P(1,2)]
Branch 1 $ 2,238.32 .02 $ 44.77 $ 2,238.32 .02 $ 101,730.27
Branch 2 $ 1,331.29 .12 $159.75 $ 1,331.29 .12 $ 218,149.55
Branch 3 $ 1,059.18 .06 $ 63.55 $ 1,059.18 .06 $ 69,491.09
Branch 4 $ 344.90 .21 $ 72.43 $ 344.90 .21 $ 27,505.56
Branch 5 $ 72.79 .24 $ 17.47 $ 72.79 .24 $ 1,935.37
Branch 6 -$ 199.32 .15 -$ 29.90 -$ 199.32 .15 $ 4,985.54
Branch 7 -$ 1,017.91 .02 -$ 20.36 -$ 1,017.91 .02 $ 20,036.02
Branch 8 -$ 1,562.13 .10 -$156.21 -$ 1,562.13 .10 $ 238,739.58
Branch 9 -$ 2,106.35 .08 -$168.51 -$ 2,106.35 .08 $ 349,227.33
Expected Net Present Value = -$ 17.01 Variance = $1,031,800.31
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Summary of the
Decision Tree Analysis Simulation Approach

The standard deviation = An approach that allows us to test

SQRT ($1,031,800) = $1,015.78 the possible results of an
investment proposal before it is
The expected NPV = -$ 17.01 accepted. Testing is based on a
model coupled with probabilistic
information.

14-29 14-30

Simulation Approach Simulation Approach

Factors we might consider in a model:
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
14-31
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.
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Pearson Education Limited 2004 Carroll College, Waukesha, WI
 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Contribution
Contribution to
to Total
Total Firm
Firm Risk:
Risk:
Simulation Approach Firm-Portfolio Approach
Firm-Portfolio Approach
Each proposal will generate an internal rate of
Combination of
return.
return The process of generating many, many Proposal A Proposal B Proposals A and B
simulations results in a large set of internal

CASH FLOW
rates of return. The distribution might look like
the following:
OF OCCURRENCE
PROBABILITY

TIME TIME TIME

Combining projects in this manner reduces

INTERNAL RATE OF RETURN (%) the firm risk due to diversification.
diversification
14-33 14-34

Determining
Determining the
the Expected
Expected Determining Portfolio
NPV
NPV for
for aa Portfolio
Portfolio of
of Projects
Projects Standard Deviation
m
NPVP = ( NPVj )
m m
j=1
P =
j=1 k=1 jk
NPVP is the expected portfolio NPV, jk is the covariance between possible
NPVs for projects j and k,
NPVj is the expected NPV of the jth
jk = j k r jk .
NPV that the firm undertakes,
j is the standard deviation of project j,
m is the total number of projects in k is the standard deviation of project k,
the firm portfolio. rjk is the correlation coefficient between
14-35 14-36 projects j and k.

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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Combinations of
Risky Investments Managerial (Real) Options
E: Existing Projects Management flexibility to make

Expected Value of NPV

C
8 Combinations future decisions that affect a
B
E E+1 E+1+2 projects expected cash flows, life,
E+2 E+1+3
E+3 E+2+3
E or future acceptance.
E+1+2+3 Project Worth = NPV +
A
A, B, and C are Option(s) Value
dominating combinations
from the eight possible. Standard Deviation
14-37 14-38

Previous Example with

Managerial (Real) Options Project Abandonment
(.10) $2,200
Expand (or contract) Assume that
(.20
.20) $1,200 1 (.60) $1,200 this project
Allows the firm to expand (contract) production (.30) $ 900 can be
if conditions become favorable (unfavorable). abandoned at
(.35) $ 900 the end of the
Abandon (.60
60) $450 (.40) $ 600 first year for
-$900 2
Allows the project to be terminated early. (.25) $ 300 $200.
$200

Postpone (.10) $ 500 What is the

(.20
.20) -$600 3 (.50) -$ 100 project
Allows the firm to delay undertaking a project
(.40) -$ 700 worth?
worth
(reduces uncertainty via new information).
Year 1 Year 2
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 Fundamentals of Financial Management, 12/e
Chapter 14: Risk and Managerial Options in Capital Budgeting

Project Abandonment Project Abandonment

(.10) $2,200 (.10) $2,200
Node 3:
3 The optimal
(.20
.20) $1,200 1 (.60) $1,200 (.20
.20) $1,200 1 (.60) $1,200 decision at the
(.30) $ 900 (500
500/1.05)(.1)+ (.30) $ 900 end of Year 1
(--100/1.05)(.5)+
100 is to abandon
(.35) $ 900 (--700/1.05)(.4)=
700 (.35) $ 900 the project for
(.60
60) $450 (.40) $ 600 (.60
60) $450 (.40) $ 600 $200.
$200
-$900 2 -$900 2
(.25) $ 300 ($476.19)(.1)+ (.25) $ 300 $200 >
-($ 95.24)(.5)+
(.10) $ 500 -($666.67)(.4)= (.10) $ 500 -($266.67)
(.20
.20) -$600 3 (.50) -$ 100 (.20
.20) -$600 3 (.50) -$ 100 What is the
(.40) -$ 700 -($266.67) (.40) -$ 700 new
new project
value?
Year 1 Year 2 Year 1 Year 2
14-41 14-42

Summary of the Addition

Project Abandonment of the Abandonment Option
(.10) $2,200
$ 2,238.32 The standard deviation* =
(.20
.20) $1,200 1 (.60) $1,200
$ 1,331.29 SQRT (740,326) = $857.56
(.30) $ 900
$ 1,059.18 The expected NPV* = $ 71.88
(.35) $ 900
$ 344.90
-$900
(.60
60) $450
2
(.40) $ 600
$ 72.79
NPV* = Original NPV +
(.25) $ 300
-$ 199.32
Abandonment Option

(.20
.20) -$400* 3 (1.0) $ 0 Thus, $71.88 = -$17.01 + Option
-$ 1,280.95
*-$600 + $200 abandonment Abandonment Option = $ 88.89
Year 1 Year 2 * For True Project considering abandonment option
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