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The
Total
Project Risk
Managerial
14-2
Options
Project Risk
The
14-3
Cash Flow
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
$ -3,000
1,000
5,000
9,000
13,000
14-4
.05
.25
.40
.25
.05
Cash Flow
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
$ -1,000
2,000
5,000
8,000
11,000
14-5
.05
.25
.40
.25
.05
Probability Distribution
of Year 1 Cash Flows
Proposal A
Probability
.40
.25
.05
-3,000
1,000
5,000
9,000
13,000
Probability Distribution
of Year 1 Cash Flows
Proposal B
Probability
.40
.25
.05
-3,000
1,000
5,000
9,000
13,000
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)
(CF1)(P1)
$ -150
250
2,000
2,250
650
CF1= $5,000
14-10
(CF1 - CF1)2(P1)
( -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)
14-11
(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
14-12
Probability
.05
.25
.40
.25
.05
Cash Flow
$ -1,000
2,000
5,000
8,000
11,000
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
14-15
(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
14-16
(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
14-18
1
14-19
3
Year
1
14-20
3
Year
-$900
14-22
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
-$900
14-23
(.20) $1,200 1
(.60)
$450
(.20)
-$600 3
Year 1
-$900
(.60)
60
(.20)
.20
14-24
$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
-$900
(.60)
60
(.20)
.20
14-25
$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
The probability
tree accounts for
the distribution
of cash flows.
Therefore,
discount all cash
flows at only the
risk-free rate of
return.
14-26
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
-$900
(.60)
60
(.20)
.20
14-27
$450
-$600 3
Year 1
(.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
Discount rate = 5%
(.20)
.20 $1,200 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
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
P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08
Variance = $1,031,800.31
14-29
Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV
14-30
= -$
17.01
14-31
Abandon
Postpone
14-32
14-33
Employing
enterprise
If a project has no external market value or
alternative use then its abandonment value is
zero.
14-34
abandoned
14-36
-$900
(.60)
60
(.20)
.20
14-37
$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
14-38
$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
14-39
$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) $
Year 1
Year 2
$ 2,238.32
$ 1,331.29
$ 1,059.18
$
344.90
72.79
-$
199.32
-$ 1,280.95