Download presentation

Presentation is loading. Please wait.

Published byChase Coyle Modified over 4 years ago

1
14-1 Chapter 14 Risk and Managerial (Real) Options in Capital Budgeting © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

2
14-2 After studying Chapter 14, you should be able to: u Define the "riskiness" of a capital investment project. u Understand how cash-flow riskiness for a particular period is measured, including the concepts of expected value, standard deviation, and coefficient of variation. u Describe methods for assessing total project risk, including a probability approach and a simulation approach. u Judge projects with respect to their contribution to total firm risk (a firm-portfolio approach). u Understand how the presence of managerial (real) options enhances the worth of an investment project. u List, discuss, and value different types of managerial (real) options.

3
14-3 Risk and Managerial (Real) Options in Capital Budgeting u The Problem of Project Risk u Total Project Risk u Contribution to Total Firm Risk: Firm-Portfolio Approach u Managerial (Real) Options u The Problem of Project Risk u Total Project Risk u Contribution to Total Firm Risk: Firm-Portfolio Approach u Managerial (Real) Options

4
14-4 An Illustration of Total Risk (Discrete Distribution) ANNUAL CASH FLOWS: YEAR 1 PROPOSAL A ProbabilityCash Flow State Probability Cash 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 1 PROPOSAL A ProbabilityCash Flow State Probability Cash 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

5
14-5 Probability Distribution of Year 1 Cash Flows.40.05.25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow ($) Proposal A

6
14-6 CF 1 P 1 CF 1 )(P 1 ) CF 1 P 1 (CF 1 )(P 1 ) $ -3,000.05 $ -150 1,000.25 250 5,000.40 2,000 9,000.25 2,250 13,000.05 650 1.00 CF 1 $5,000 =1.00 CF 1 =$5,000 CF 1 P 1 CF 1 )(P 1 ) CF 1 P 1 (CF 1 )(P 1 ) $ -3,000.05 $ -150 1,000.25 250 5,000.40 2,000 9,000.25 2,250 13,000.05 650 1.00 CF 1 $5,000 =1.00 CF 1 =$5,000 Expected Value of Year 1 Cash Flows (Proposal A)

7
14-7 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) 2 (.05) $ -150 ( -3,000 - 5,000) 2 (.05) 2 (.25) 250 ( 1,000 - 5,000) 2 (.25) 2 (.40) 2,000 ( 5,000 - 5,000) 2 (.40) 2 (.25) 2,250 ( 9,000 - 5,000) 2 (.25) 2 (.05) 650 (13,000 - 5,000) 2 (.05) $5,000 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) 2 (.05) $ -150 ( -3,000 - 5,000) 2 (.05) 2 (.25) 250 ( 1,000 - 5,000) 2 (.25) 2 (.40) 2,000 ( 5,000 - 5,000) 2 (.40) 2 (.25) 2,250 ( 9,000 - 5,000) 2 (.25) 2 (.05) 650 (13,000 - 5,000) 2 (.05) $5,000 Variance of Year 1 Cash Flows (Proposal A)

8
14-8 Variance of Year 1 Cash Flows (Proposal A) CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 *(P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 *(P 1 ) $ -150 3,200,000 250 4,000,000 2,000 0 2,250 4,000,000 650 3,200,000 $5,000 14,400,000 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 *(P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 *(P 1 ) $ -150 3,200,000 250 4,000,000 2,000 0 2,250 4,000,000 650 3,200,000 $5,000 14,400,000

9
14-9 Summary of Proposal A standard deviation $3,795 The standard deviation = SQRT (14,400,000) = $3,795 expected cash flow $5,000 The expected cash flow = $5,000 Coefficient of Variation (CV) = $3,795 / $5,000 = 0.759 CV is a measure of relative risk and is the ratio of standard deviation to the mean of the distribution.

10
14-10 An Illustration of Total Risk (Discrete Distribution) ANNUAL CASH FLOWS: YEAR 1 PROPOSAL B ProbabilityCash Flow State Probability Cash 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 1 PROPOSAL B ProbabilityCash Flow State Probability Cash 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

11
14-11 Probability Distribution of Year 1 Cash Flows.40.05.25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow ($) Proposal B

12
14-12 Expected Value of Year 1 Cash Flows (Proposal B) CF 1 P 1 CF 1 )(P 1 ) CF 1 P 1 (CF 1 )(P 1 ) $ -1,000.05 $ -50 2,000.25 500 5,000.40 2,000 8,000.25 2,000 11,000.05 550 1.00 CF 1 $5,000 =1.00 CF 1 =$5,000 CF 1 P 1 CF 1 )(P 1 ) CF 1 P 1 (CF 1 )(P 1 ) $ -1,000.05 $ -50 2,000.25 500 5,000.40 2,000 8,000.25 2,000 11,000.05 550 1.00 CF 1 $5,000 =1.00 CF 1 =$5,000

13
14-13 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) 2 (.05) $ -50 ( -1,000 - 5,000) 2 (.05) 2 (.25) 500 ( 2,000 - 5,000) 2 (.25) 2 (.40) 2,000 ( 5,000 - 5,000) 2 (.40) 2 (.25) 2,000 ( 8,000 - 5,000) 2 (.25) 2 (.05) 550 (11,000 - 5,000) 2 (.05) $5,000 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) 2 (.05) $ -50 ( -1,000 - 5,000) 2 (.05) 2 (.25) 500 ( 2,000 - 5,000) 2 (.25) 2 (.40) 2,000 ( 5,000 - 5,000) 2 (.40) 2 (.25) 2,000 ( 8,000 - 5,000) 2 (.25) 2 (.05) 550 (11,000 - 5,000) 2 (.05) $5,000 Variance of Year 1 Cash Flows (Proposal B)

14
14-14 Variance of Year 1 Cash Flows (Proposal B) CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) $ -50 1,800,000 500 2,250,000 2,000 0 2,000 2,250,000 550 1,800,000 $5,000 8,100,000 CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) (CF 1 )(P 1 ) (CF 1 - CF 1 ) 2 (P 1 ) $ -50 1,800,000 500 2,250,000 2,000 0 2,000 2,250,000 550 1,800,000 $5,000 8,100,000

15
14-15 Summary of Proposal B B < A ($2,846< $3,795), so B is less risky than A. The standard deviation of B < A ($2,846< $3,795), so B is less risky than A. The coefficient of variation of B < A (0.569<0.759), so B has less relative risk than A. standard deviation $2,846 The standard deviation = SQRT (8,100,000) = $2,846 expected cash flow $5,000 The expected cash flow = $5,000 Coefficient of Variation (CV) = $2,846 / $5,000 = 0.569

16
14-16 Total Project Risk Projects have risk that may change from period to period. Projects are more likely to have continuous, rather than discrete distributions. Cash Flow ($) 123 1 2 3 Year

17
14-17 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.

18
14-18 Probability Tree Approach initial cost $900 Year 1 Basket Wonders is examining a project that will have an initial cost today of $900. Uncertainty surrounding the first year cash flows creates three possible cash-flow scenarios in Year 1. -$900

19
14-19 Probability Tree Approach $1,200 Node 1: 20% chance of a $1,200 cash-flow. $450 Node 2: 60% chance of a $450 cash-flow. -$600 Node 3: 20% chance of a -$600 cash-flow. -$900 $1,200 (.20) $1,200 -$600 (.20) -$600 $450 (.60) $450 Year 1 1 2 3

20
14-20 Probability Tree Approach Year 2 branch Each node in Year 2 represents a branch of our probability tree. conditional probabilities The probabilities are said to be conditional probabilities. -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2

21
14-21 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 -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2

22
14-22 Project NPV Based on Probability Tree Usage risk-free The probability tree accounts for the distribution of cash flows. Therefore, discount all cash flows at only the risk-free rate of return. NPV for branch i The NPV for branch i of the probability tree for two years of cash flows is NPV i P i NPV = (NPV i )(P i ) NPV i NPV i = CF 1 R f 1 (1 + R f ) 1 R f 2 (1 + R f ) 2 CF 2 ICO - ICO + i = 1 z

23
14-23 NPV for Each Cash-Flow Stream 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 -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2

24
14-24 NPV on the Calculator Remember, we can use the cash flow registry to solve these NPV problems quickly and accurately!

25
14-25 Actual NPV Solution Using Your Financial Calculator Solving for Branch #3: Step 1:PressCF key Step 2:Press2 nd CLR Workkeys 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

26
14-26 Actual NPV Solution Using Your Financial Calculator Solving for Branch #3: Step 8: Press keys Step 9: PressNPV key Step 10: For I=, Enter 5Enter keys Step 11: PressCPT key Result:Net Present Value = $1,059.18 You would complete this for EACH branch!

27
14-27 Calculating the Expected Net Present Value (NPV) NPV i Branch NPV i Branch 1 $ 2,238.32 Branch 2 $ 1,331.29 Branch 3 $ 1,059.18 Branch 4 $ 344.90 Branch 5 $ 72.79 Branch 6 -$ 199.32 Branch 7 -$ 1,017.91 Branch 8-$ 1,562.13 Branch 9 -$ 2,106.35 P(1,2) NPV i P(1,2) P(1,2) NPV i * 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 Expected Net Present Value = -$ 17.01

28
14-28 Calculating the Variance of the Net Present Value NPV i NPV i $ 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) (NPV i NPVP(1,2) P(1,2) (NPV i - NPV ) 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 $1,031,800.31 Variance = $1,031,800.31

29
14-29 Summary of the Decision Tree Analysis standard deviation $1,015.78 The standard deviation = SQRT ($1,031,800) = $1,015.78 expected NPV -$ 17.01 The expected NPV = -$ 17.01

30
14-30 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.

31
14-31 Simulation Approach Market analysis u Market analysis u Market size, selling price, market growth rate, and market share Investment cost analysis u Investment cost analysis u Investment required, useful life of facilities, and residual value Operating and fixed costs u Operating and fixed costs u Operating costs and fixed costs Factors we might consider in a model:

32
14-32 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.

33
14-33 Simulation Approach internal rate of return distribution Each proposal will generate an internal rate of 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: INTERNAL RATE OF RETURN (%) PROBABILITY OF OCCURRENCE

34
14-34 diversification Combining projects in this manner reduces the firm risk due to diversification. Contribution to Total Firm Risk: Firm-Portfolio Approach CASH FLOW TIME Proposal A Proposal B Combination of Proposals A and B

35
14-35 NPV P = ( NPV j ) NPV P is the expected portfolio NPV, NPV j is the expected NPV of the jth NPV that the firm undertakes, m is the total number of projects in the firm portfolio. NPV P = ( NPV j ) NPV P is the expected portfolio NPV, NPV j 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 NPV for a Portfolio of Projects m j=1

36
14-36 P P = jk jk is the covariance between possible NPVs for projects j and k r jk = j k r jk. j is the standard deviation of project j, k is the standard deviation of project k, r jk is the correlation coefficient between projects j and k. P P = jk jk is the covariance between possible NPVs for projects j and k r jk = j k r jk. j is the standard deviation of project j, k is the standard deviation of project k, r jk is the correlation coefficient between projects j and k. Determining Portfolio Standard Deviation m j=1 m k=1

37
14-37 E: Existing Projects 8 Combinations EEE EE EE EE + 1 E + 1 + 2 E + 2 E + 1 + 3 E + 3 E + 2 + 3 E E + 1 + 2 + 3 ABC dominating A, B, and C are dominating combinations from the eight possible. Combinations of Risky Investments A B C E Standard Deviation Expected Value of NPV

38
14-38 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

39
14-39 Managerial (Real) Options Expand (or contract) u Allows the firm to expand (contract) production if conditions become favorable (unfavorable).Abandon u Allows the project to be terminated early.Postpone u Allows the firm to delay undertaking a project (reduces uncertainty via new information).

40
14-40 Previous Example with Project Abandonment $200 Assume that this project can be abandoned at the end of the first year for $200. project worth What is the project worth? -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2

41
14-41 Project Abandonment Node 3 Node 3: 500 -100 -700 (500/1.05)(.1)+ (-100/1.05)(.5)+ (-700/1.05)(.4)= ($476.19)(.1)+ -($ 95.24)(.5)+ -($666.67)(.4)=-($266.67) -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2

42
14-42 Project Abandonment -$900.20$1,200 (.20) $1,200.20-$600 (.20) -$600 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 500 (.10) $ 500 -$ 100 (.50) -$ 100 -$ 700 (.40) -$ 700 Year 2 Year 1 $200 The optimal decision at the end of Year 1 is to abandon the project for $200. $200 $200 >-($266.67) new What is the new project value?

43
14-43 Project Abandonment $ 2,238.32 $ 1,331.29 $ 1,059.18 $ 344.90 $ 72.79 -$ 199.32 -$ 1,280.95 -$900.20$1,200 (.20) $1,200.20-$400* (.20) -$400* 60$450 (.60) $450 Year 1 1 2 3 $1,200 (.60) $1,200 $ 900 (.30) $ 900 $2,200 (.10) $2,200 $ 900 (.35) $ 900 $ 600 (.40) $ 600 $ 300 (.25) $ 300 $ 0 (1.0) $ 0 Year 2 *-$600 + $200 abandonment

44
14-44 Summary of the Addition of the Abandonment Option * For True Project considering abandonment option standard deviation* $857.56 The standard deviation*= SQRT (740,326) = $857.56 expected NPV* $ 71.88 The expected NPV* = $ 71.88 NPV* Abandonment Option NPV* = Original NPV + Abandonment Option Thus, $71.88 Option Thus, $71.88 = -$17.01 + Option Abandonment Option $ 88.89 Abandonment Option = $ 88.89

Similar presentations

OK

AGVISE Laboratories %Zone or Grid Samples – Northwood laboratory

AGVISE Laboratories %Zone or Grid Samples – Northwood laboratory

© 2018 SlidePlayer.com Inc.

All rights reserved.

Ads by Google

Ppt on isobars and isotopes Ppt on product advertising slogan Ppt on bill gates life Ppt on abo blood grouping images Ppt on national education day essay Ppt on indian army weapons planes Ppt on network switching types Ppt on current environmental issues Ppt on product design and development Ppt online shopping project proposal