Chapter 14

Risk and Managerial

Options in Capital
Budgeting
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
14-1
 Risk and Managerial
Options in Capital Budgeting

The Problem of Project Risk

Total Project Risk
Contribution to Total Firm Risk:
Firm-Portfolio Approach
Managerial Options

14-2
 An Illustration of Total Risk
(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
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
14-3
 Probability Distribution
of Year 1 Cash Flows
Proposal A
.40
Probability

.25

.05

-3,000 1,000 5,000 9,000 13,000

Cash Flow ($)
14-4
 Expected Value of Year 1
Cash Flows (Proposal A)
CF1 P1 (CF1)(P1)
$ -3,000 .05 $ -150
1,000 .25 250
5,000 .40 2,000
9,000 .25 2,250
13,000 .05 650
S=1.00 CF1=$5,000
14-5
 Variance of Year 1
Cash Flows (Proposal A)

(CF1)(P1) (CF1 - CF1)2(P1)

$ -150 ( -3,000 - 5,000)2 (.05)
250 ( 1,000 - 5,000)2 (.25)
2,000 ( 5,000 - 5,000)2 (.40)
2,250 ( 9,000 - 5,000)2 (.25)
650 (13,000 - 5,000)2 (.05)
$5,000
14-6
 Variance of Year 1
Cash Flows (Proposal A)

(CF1)(P1) (CF1 - CF1)2*(P1)

$ -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
14-7
 Summary of Proposal A

The standard deviation =

SQRT (14,400,000) = $3,795

The expected cash flow = $5,000

14-8
 An Illustration of Total Risk
(Discrete Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
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
14-9
 Probability Distribution
of Year 1 Cash Flows
Proposal B
.40
Probability

.25

.05

-3,000 1,000 5,000 9,000 13,000

Cash Flow ($)
14-10
 Expected Value of Year 1
Cash Flows (Proposal B)
CF1 P1 (CF1)(P1)
$ -1,000 .05 $ -50
2,000 .25 500
5,000 .40 2,000
8,000 .25 2,000
11,000 .05 550
S=1.00 CF1=$5,000
14-11
 Variance of Year 1
Cash Flows (Proposal B)

(CF1)(P1) (CF1 - CF1)2(P1)

$ -50 ( -1,000 - 5,000)2 (.05)
500 ( 2,000 - 5,000)2 (.25)
2,000 ( 5,000 - 5,000)2 (.40)
2,000 ( 8,000 - 5,000)2 (.25)
550 (11,000 - 5,000)2 (.05)
$5,000
14-12
 Variance of Year 1
Cash Flows (Proposal B)

(CF1)(P1) (CF1 - CF1)2(P1)

$ -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
14-13
 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 )
14-14
 Total Project Risk
Projects have risk
that may change
from period to

Cash Flow ($)

period.
Projects are more
likely to have
continuous, rather
than discrete
distributions.
1 2 3
14-15 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.
14-16
 Probability Tree Approach

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.
14-17
 Probability Tree Approach

(.20) $1,200 1 Node 1: 20% chance of a

$1,200 cash-flow.

(.60) $450 Node 2: 60% chance of a

-$900 2
$450 cash-flow.

(.20) -$600 3 Node 3: 20% chance of a

-$600 cash-flow.
Year 1
14-18
 Probability Tree Approach
(.10) $2,200
Each node in
(.20) $1,200 1 (.60) $1,200 Year 2
(.30) $ 900 represents a
branch of our
(.35) $ 900 probability
(.60) $450 (.40) $ 600 tree.
-$900 2
(.25) $ 300
The
(.10) $ 500 probabilities
(.20) -$600 3 (.50) -$ 100 are said to be
(.40) -$ 700 conditional
probabilities.
Year 1 Year 2
14-19
 Joint Probabilities [P(1,2)]
(.10) $2,200
.02 Branch 1
(.20) $1,200 1 (.60) $1,200
.12 Branch 2
(.30) $ 900
.06 Branch 3
(.35) $ 900
.21 Branch 4
(.60) $450 (.40) $ 600
-$900 2 .24 Branch 5
(.25) $ 300
.15 Branch 6
(.10) $ 500
.02 Branch 7
(.20) -$600 3 (.50) -$ 100
.10 Branch 8
(.40) -$ 700
.08 Branch 9
Year 1 Year 2
14-20
 Project NPV Based on
Probability Tree Usage
z
The probability NPV = iS= 1 (NPVi)(Pi)
tree accounts for
the distribution
of cash flows. The NPV for branch i of
Therefore, the probability tree for two
discount all cash years of cash flows is
flows at only the CF1 CF2
risk-free rate of NPVi = +
(1 + Rf )1 (1 + Rf )2
return.
- ICO
14-21
 NPV for Each Cash-Flow
Stream at 5% Risk-Free Rate
(.10) $2,200
$ 2,238.32
(.20) $1,200 1 (.60) $1,200
$ 1,331.29
(.30) $ 900
$ 1,059.18
(.35) $ 900
$ 344.90
(.60) $450 (.40) $ 600
-$900 2 $ 72.79
(.25) $ 300
-$ 199.32
(.10) $ 500
-$ 1,017.91
(.20) -$600 3 (.50) -$ 100
-$ 1,562.13
(.40) -$ 700
-$ 2,106.35
Year 1 Year 2
14-22
 NPV on the Calculator

Remember, we can
use the cash flow
registry to solve
these NPV problems
quickly and
accurately!

14-23
 Actual NPV Solution Using
Your Financial Calculator

Solving for Branch #3:

Step 1: Press CF key
Step 2: Press 2nd CLR Work keys
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

14-24
 Actual NPV Solution Using
Your Financial Calculator
Solving for Branch #3:
Step 8: Press   keys
Step 9: Press NPV key
Step 10: For I=, Enter 5 Enter  keys
Step 11: Press CPT key

Result: Net Present Value = $1,059.18

You would complete this for EACH branch!

14-25
 Calculating the Expected
Net Present Value (NPV)
Branch NPVi P(1,2) NPVi * P(1,2)
Branch 1 $ 2,238.32 .02 $ 44.77
Branch 2 $ 1,331.29 .12 $159.75
Branch 3 $ 1,059.18 .06 $ 63.55
Branch 4 $ 344.90 .21 $ 72.43
Branch 5 $ 72.79 .24 $ 17.47
Branch 6 -$ 199.32 .15 -$ 29.90
Branch 7 -$ 1,017.91 .02 -$ 20.36
Branch 8 -$ 1,562.13 .10 -$156.21
Branch 9 -$ 2,106.35 .08 -$168.51
Expected Net Present Value = -$ 17.01
14-26
 Calculating the Variance
of the Net Present Value
NPVi P(1,2) (NPVi - NPV )2[P(1,2)]
$ 2,238.32 .02 $ 101,730.27
$ 1,331.29 .12 $ 218,149.55
$ 1,059.18 .06 $ 69,491.09
$ 344.90 .21 $ 27,505.56
$ 72.79 .24 $ 1,935.37
-$ 199.32 .15 $ 4,985.54
-$ 1,017.91 .02 $ 20,036.02
-$ 1,562.13 .10 $ 238,739.58
-$ 2,106.35 .08 $ 349,227.33
Variance = $1,031,800.31
14-27
 Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78

The expected NPV = -$ 17.01

14-28
 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.

14-29
 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
14-30
 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.
14-31
 Simulation Approach
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:
OF OCCURRENCE
PROBABILITY

INTERNAL RATE OF RETURN (%)

14-32
 Contribution to Total Firm Risk:
Firm-Portfolio Approach

Combination of
Proposal A Proposal B Proposals A and B
CASH FLOW

TIME TIME TIME

Combining projects in this manner reduces

the firm risk due to diversification.
14-33
 Determining the Expected
NPV for a Portfolio of Projects
m
NPVP = S ( 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.
14-34
 Determining Portfolio
Standard Deviation
m m
sP = S k=1
S sjk
j=1
sjk is the covariance between possible
NPVs for projects j and k,
s jk = s j s k r jk .
sj is the standard deviation of project j,
sk is the standard deviation of project k,
rjk is the correlation coefficient between
14-35 projects j and k.
 Combinations of
Risky Investments
E: Existing Projects

Expected Value of NPV

C
8 Combinations
B
E E+1 E+1+2
E+2 E+1+3 E
E+3 E+2+3
E+1+2+3
A
A, B, and C are
dominating combinations
from the eight possible. Standard Deviation
14-36
 Managerial (Real) Options

Management flexibility to make

future decisions that affect a
project’s expected cash flows, life,
or future acceptance.
Project Worth = NPV +
Option(s) Value

14-37
 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
 Allowsthe firm to delay undertaking a project
(reduces uncertainty via new information).
14-38
 Previous Example with
Project Abandonment
(.10) $2,200
Assume that
(.20) $1,200 1 (.60) $1,200 this project
(.30) $ 900 can be
abandoned at
(.35) $ 900 the end of the
(.60) $450 (.40) $ 600 first year for
-$900 2
(.25) $ 300 $200.
(.10) $ 500 What is the
(.20) -$600 3 (.50) -$ 100 project
(.40) -$ 700 worth?
Year 1 Year 2
14-39
 Project Abandonment
(.10) $2,200
Node 3:
(.20) $1,200 1 (.60) $1,200
(.30) $ 900 (500/1.05)(.1)+
(-100/1.05)(.5)+
(.35) $ 900 (-700/1.05)(.4)=
(.60) $450 (.40) $ 600
-$900 2
(.25) $ 300 ($476.19)(.1)+
-($ 95.24)(.5)+
(.10) $ 500 -($666.67)(.4)=
(.20) -$600 3 (.50) -$ 100
(.40) -$ 700 -($266.67)
Year 1 Year 2
14-40
 Project Abandonment
(.10) $2,200
The optimal
(.20) $1,200 1 (.60) $1,200 decision at the
(.30) $ 900 end of Year 1 is
to abandon the
(.35) $ 900 project for
(.60) $450 (.40) $ 600 $200.
-$900 2
(.25) $ 300 $200 >
(.10) $ 500 -($266.67)
(.20) -$600 3 (.50) -$ 100 What is the
(.40) -$ 700 “new” project
value?
Year 1 Year 2
14-41
 Project Abandonment
(.10) $2,200
$ 2,238.32
(.20) $1,200 1 (.60) $1,200
$ 1,331.29
(.30) $ 900
$ 1,059.18
(.35) $ 900
$ 344.90
(.60) $450 (.40) $ 600
-$900 2 $ 72.79
(.25) $ 300
-$ 199.32

(.20) -$400* 3 (1.0) $ 0

-$ 1,280.95
*-$600 + $200 abandonment
Year 1 Year 2
14-42
 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
14-43 * For “True” Project considering abandonment option