Lecture 9

Risk and Managerial

Options in Capital
Budgeting
Instructor: Muhammad Nouman
14-1

Risk and Managerial

Options in Capital Budgeting

The

Problem of Project Risk

Total

Project Risk

Managerial

14-2

Options

Project Risk

The variability of a projects

cash flows from those that are
expected.

The

greater the variability, the

riskier the project is said to be.

14-3

An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
State of Economy Probability

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

An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State of Economy Probability

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

Cash Flow ($)

14-6

13,000

Probability Distribution
of Year 1 Cash Flows
Proposal B

Probability

.40
.25

.05
-3,000

1,000

5,000

9,000

Cash Flow ($)

14-7

13,000

Expectation & Measurement

of Dispersion
Expected value: The weighted average of
possible outcomes, with the weights
being the probabilities of occurrence.
Standard
deviation:
A
statistical
measure of the variability of a
distribution around its mean.
14-8

Expected Value of Year 1

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

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

An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
14-13

Probability
.05
.25
.40
.25
.05

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

Expected Value of Year 1

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

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

The expected cash flow = $5,000

The standard deviation of
Proposal B < Proposal A.
( $2,846 < $3,795 )
14-17

Total Project Risk

The riskiness of a stream of cash
flows for a project can, and often does,
change with the length of time in the
future that the flows occur.

In other words, the probability

distributions are not necessarily the
same from one period to the next.

14-18

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
14-19

3
Year

The cash-flow outcome

for each period can take
on any value within a
given interval as
opposed to taking on
only certain values
within an interval.
The tighter and more
peaked the distribution,
the less risk

Cash Flow ($)

Total Project Risk

1
14-20

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.
14-21

Probability Tree Approach

-$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

Probability Tree Approach

-$900

14-23

(.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

14-24

$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

Joint Probabilities [P(1,2)]

(.20)
.20 $1,200 1

-$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

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.
14-26

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

NPV for Each Cash-Flow

Stream at 5% Risk-Free Rate

-$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

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

14-28

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
14-29

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

14-30

= -$

17.01

Managerial (Real) Options

Management flexibility to make
future decisions that affect a
projects expected cash flows, life,
or future acceptance.

14-31

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

14-32

Allows the firm to delay undertaking a project

(reduces uncertainty via new information).

Managerial (Real) Options

Project Worth = NPV + Option(s) Value

14-33

The Option to Abandon

The option of abandoning a project may
consist of:

Selling the projects assets

Employing

them in other area of the

enterprise
If a project has no external market value or
alternative use then its abandonment value is
zero.
14-34

The Option to Abandon

Abandonment value
The value of a project if the projects assets were
sold externally; or alternatively, its opportunity
value if the assets were employed elsewhere in
the firm.
Project worth = NPV without abandonment option
+ Value of abandonment option
14-35

The Option to Abandon

An investment project should be
when

abandoned

its abandonment value exceeds the present

value of the projects subsequent future cash
flows, and

it is better to abandon the project at that time

than it is to abandon it at some future date.

14-36

Previous Example with

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

-$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) $

*-$600 + $200 abandonment

14-40

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
14-41

* For True Project considering abandonment option