Chapter 14

Chapter 14
Risk and Managerial

(Real) Options in
Capital Budgeting
14.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 14,

you should be able to:
1.
2.
3.
4.
5.
6.
14.2
Define the "riskiness" of a capital investment project.

Understand how cash-flow riskiness for a particular
period is measured, including the concepts of
expected value, standard deviation, and coefficient of
variation.
Describe methods for assessing total project risk,
including a probability approach and a simulation
approach.
Judge projects with respect to their contribution to
total firm risk (a firm-portfolio approach).
Understand how the presence of managerial (real)
options enhances the worth of an investment project.
List, discuss, and value different types of managerial
(real) options.
Risk and Managerial

Options in Capital Budgeting
14.3
The Problem of Project Risk
Total Project Risk
Contribution to Total Firm Risk:

Firm-Portfolio Approach
Managerial 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
14.4
Probability
Cash Flow
0.05
0.25
0.40
0.25
0.05
$ 3,000
1,000
5,000
9,000
13,000
Probability Distribution
of Year 1 Cash Flows
Proposal A
Probability
0.40
0.25
0.05
3,000
1,000
5,000
9,000
13,000
Cash Flow ($)

14.5
Expected Value of Year 1

Cash Flows (Proposal A)
CF1
$ 3,000
1,000
5,000
9,000
13,000
14.6
P1
0.05
0.25
0.40
0.25
0.05
=1.00
(CF1)(P1)
$ 150
250
2,000
2,250
650
CF1=$5,000
Variance of Year 1
(CF1)(P1)
$ 150
250
2,000
2,250
650
$5,000
14.7
(CF1 CF1)2(P1)
(3,000 5,000)2 (0.05)
( 1,000 5,000)2 (0.25)
( 5,000 5,000)2 (0.40)
( 9,000 5,000)2 (0.25)
(13,000 5,000)2 (0.05)
Variance of Year 1
(CF1)(P1)
$ 150
250
2,000
2,250
650
$5,000
14.8
(CF1 CF1)2*(P1)
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
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.
14.9
An Illustration of Total Risk

(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State
Deep Recession
Mild Recession
Normal
Minor Boom
Major Boom
14.10
Probability
Cash Flow
0.05
0.25
0.40
0.25
0.05
$ 1,000
2,000
5,000
8,000
11,000
Probability Distribution
of Year 1 Cash Flows
Proposal B
Probability
0.40
0.25
0.05
3,000
1,000
5,000
9,000
13,000
Cash Flow ($)

14.11
Expected Value of Year 1

Cash Flows (Proposal B)
CF1
$ 1,000
2,000
5,000
8,000
11,000
14.12
P1
0.05
0.25
0.40
0.25
0.05
=1.00
(CF1)(P1)
$ 50
500
2,000
2,000
550
CF1=$5,000
Variance of Year 1
(CF1)(P1)
$ 50
500
2,000
2,000
550
$5,000
14.13
(CF1 CF1)2(P1)
(1,000 5,000)2 (0.05)
( 2,000 5,000)2 (0.25)
( 5,000 5,000)2 (0.40)
( 8,000 5,000)2 (0.25)
(11,000 5,000)2 (0.05)
Variance of Year 1
(CF1)(P1)
$ 50
500
2,000
2,000
550
$5,000
14.14
(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
Coefficient of Variation (CV) = $2,846 / $5,000
= 0.569
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.
14.15
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
3
Year
14.16
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.
14.17
$900
14.18
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

(0.20) $1,200
$900
(0.60)
$450
(0.20)
$600
Node 1: 20% chance of a

$1,200 cash-flow.

$450 cash-flow.

$600 cash-flow.
Year 1
14.19

(0.20)
0.20 $1,200
$900
(0.60)
0.60
$450
(0.10) $2,200
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
(0.40) $ 600
(0.25) $ 300
(0.10) $ 500
(0.20)
0.20
Year 1
14.20
$600
(0.50) $ 100
(0.40) $ 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)]

(0.10) $2,200
(0.20)
0.20 $1,200
$900
(0.60)
0.60
$450
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
(0.40) $ 600
(0.25) $ 300
(0.10) $ 500
(0.20)
0.20
Year 1
14.21
$600
(0.50) $ 100
(0.40) $ 700
0.02 Branch 1
0.12 Branch 2
0.06 Branch 3
0.21 Branch 4
0.24 Branch 5
0.15 Branch 6
0.02 Branch 7
0.10 Branch 8
0.08 Branch 9
Year 2
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.
14.22
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
(0.10) $2,200
(0.20)
0.20 $1,200
$900
(0.60)
0.60
$450
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
(0.40) $ 600
(0.25) $ 300
(0.10) $ 500
(0.20)
0.20
Year 1
14.23
$600
(0.50) $ 100
(0.40) $ 700
$ 2,238.32
$ 1,331.29
$ 1,059.18
$
344.90
72.79
199.32
$ 1,017.91
$ 1,562.13
$ 2,106.35
Year 2
NPV on the Calculator

Remember, we can
use the cash flow
registry to solve
these NPV problems
quickly and
accurately!
Source: Courtesy of Texas Instruments
14.24
Actual NPV Solution Using

Your Financial Calculator
Solving for Branch #3:
14.25
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!

14.26
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)
0.02
0.12
0.06
0.21
0.24
0.15
0.02
0.10
0.08
NPVi * P(1,2)
$ 44.77
$159.75
$ 63.55
$ 72.43
$ 17.47
$ 29.90
$ 20.36
$156.21
$168.51
Expected Net Present Value = $ 17.01

14.27
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)
0.02
0.12
0.06
0.21
0.24
0.15
0.02
0.10
0.08
(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
14.28
Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV
14.29
= $
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.
14.30
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
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
0.02 0.08 0.22 0.36 0.22 0.08 0.02
The resulting proposal value is dependent
on the distribution and interaction of
EVERY variable listed on slide 14.31.
14.32
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:
14.33
INTERNAL RATE OF RETURN (%)

Contribution to Total Firm Risk:

Firm-Portfolio Approach
Proposal B
CASH FLOW
Proposal A
Combination of
Proposals A and B
TIME
TIME
TIME
Combining projects in this manner reduces

the firm risk due to diversification.
diversification
14.34
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.
14.35
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,
rjk is the correlation coefficient between
projects j and k.
14.36
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.
14.37
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 +
Value
14.38
Option(s)
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
14.39
Allows the firm to delay undertaking a project

(reduces uncertainty via new information).
Previous Example with

Project Abandonment
(0.20)
0.20 $1,200
1
(0.10) $2,200
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
$900
(0.60)
60
(0.20)
0.20
Year 1
14.40
$450
$600
(0.40) $ 600
(0.25) $ 300
(0.10) $ 500
(0.50)$ 100
(0.40)$ 700
Assume that
this project
can be
abandoned at
the end of the
first year for
$200.
$200
What is the
project
worth?
worth
Year 2
Project Abandonment
(0.10) $2,200
(0.20)
.20 $1,200
$900
(0.60)
60
$450
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
(0.40) $ 600
(0.25) $ 300
(0.10) $ 500
(0.20)
0.20 $600
Year 1
14.41
(0.50) $ 100
(0.40) $ 700
Node 3:
3
(500/1.05)(0.1)+
500
(100/1.05)(0.5)+
100
(700/1.05)(0.4)=
700
($476.19)(0.1)+
($ 95.24)(0.5)+
($666.67)
(0.4)=
($266.67)
Year 2
Project Abandonment
(0.10) $2,200
(0.20)
.20 $1,200
$900
(0.60)
60
(0.20)
0.20
Year 1
14.42
$450
$600
(0.35) $ 900
(0.40) $ 600
The optimal
decision at the
end of Year 1 is
to abandon the
project for
$200.
$200
(0.25) $ 300
$200 >
(0.10) $ 500
($266.67)
(0.50) $ 100
What is the
new project
value?
(0.60) $1,200
(0.30) $ 900
(0.40) $ 700
Year 2
Project Abandonment
(0.10) $2,200
(0.20)
0.20 $1,200
$900
(0.60)
60
(0.20)
0.20
$450
$400*
(0.60) $1,200
(0.30) $ 900
(0.35) $ 900
(0.40) $ 600
(0.25) $ 300
(1.0) $
$ 2,238.32
$ 1,331.29
$ 1,059.18
$
344.90
72.79
$ 199.32
$ 1,280.95
*$600 + $200 abandonment

Year 1
14.43
Year 2
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
* For True Project considering abandonment option
14.44

Chapter 14

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Chapter 14

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Chapter 14

Risk and Managerial

After Studying Chapter 14,

Define the "riskiness" of a capital investment project.

Risk and Managerial

The Problem of Project Risk

Total Project Risk

Contribution to Total Firm Risk:

An Illustration of Total Risk

Cash Flow ($)

Expected Value of Year 1

Coefficient of Variation (CV) = $3,795 / $5,000

An Illustration of Total Risk

Cash Flow ($)

Expected Value of Year 1

Projects have risk

Cash Flow ($)

Total Project Risk

Probability Tree Approach

Probability Tree Approach

Probability Tree Approach

Node 1: 20% chance of a

Node 2: 60% chance of a

Node 3: 20% chance of a

Probability Tree Approach

Joint Probabilities [P(1,2)]

Project NPV Based on

NPV for Each Cash-Flow

NPV on the Calculator

Source: Courtesy of Texas Instruments

Actual NPV Solution Using

For C01 Press

Actual NPV Solution Using

Step 10: For I=, Enter

Net Present Value = $1,059.18

You would complete this for EACH branch!

Calculating the Expected

Expected Net Present Value = $ 17.01

Calculating the Variance

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

Each proposal will generate an internal rate of

INTERNAL RATE OF RETURN (%)

Contribution to Total Firm Risk:

Combining projects in this manner reduces

Determining the Expected

NPVP is the expected portfolio NPV,

jk is the covariance between possible

j is the standard deviation of project j,

Expected Value of NPV

Managerial (Real) Options

Managerial (Real) Options

Allows the firm to expand (contract) production

Allows the project to be terminated early.

Allows the firm to delay undertaking a project

Previous Example with

*$600 + $200 abandonment

Summary of the Addition

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