Chapter 14

Risk
Risk and
and Managerial
Managerial
(Real)
(Real) Options
Options in
in
Capital
Capital Budgeting
Budgeting
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
4-1
 After studying Chapter 14,
you should be able to:
 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
4-2 (real) options.
 Risk
Risk and
and Managerial
Managerial (Real)
(Real)
Options
Options in
in Capital
Capital Budgeting
Budgeting

 The Problem of Project Risk

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

4-3
 An
An Illustration
Illustration of
of Total
Total
Risk
Risk (Discrete
(Discrete Distribution)
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
4-4
 Probability
Probability Distribution
Distribution
of
of Year
Year 11 Cash
Cash Flows
Flows
Proposal A
.40
Probability

.25

.05

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

Cash Flow ($)
4-5
 Expected
Expected Value
Value of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal AA))
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
=1.00 CF1=$5,000
4-6
 Variance
Variance of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal A
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
4-7
 Variance
Variance of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal A
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
4-8
 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.
4-9
 An
An Illustration
Illustration of
of Total
Total
Risk
Risk (Discrete
(Discrete Distribution)
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
4-10
 Probability
Probability Distribution
Distribution
of
of Year
Year 11 Cash
Cash Flows
Flows
Proposal B
.40
Probability

.25

.05

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

Cash Flow ($)
4-11
 Expected
Expected Value
Value of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal BB))
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
=1.00 CF1=$5,000
4-12
 Variance
Variance of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal B
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
4-13
 Variance
Variance of
of Year
Year 11
Cash
Cash Flows
Flows ((Proposal
Proposal B
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
4-14
 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”.

4-15
 Total Project Risk
Projects have risk
that may change
from period to
period.

Cash Flow ($)

Projects are more
likely to have
continuous, rather
than discrete
distributions.
1 2 3
4-16 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.
4-17
 Probability Tree Approach

Basket Wonders is
examining a project that will
have an initial cost today of
-$900 $900.
$900 Uncertainty
surrounding the first year
cash flows creates three
possible cash-flow
scenarios in Year 1.
1
4-18
 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
4-19
 Probability Tree Approach
(.10) $2,200
Each node in
(.20)
.20 $1,200 1 (.60) $1,200 Year 2
(.30) $ 900 represents a
branch of our
(.35) $ 900 probability
(.60)
60 $450 (.40) $ 600 tree.
-$900 2
(.25) $ 300
The
(.10) $ 500 probabilities
(.20)
.20 -$600 3 (.50) -$ 100 are said to be
(.40) -$ 700 conditional
probabilities.
probabilities
Year 1 Year 2
4-20
 Joint Probabilities [P(1,2)]
(.10) $2,200
.02 Branch 1
(.20)
.20 $1,200 1 (.60) $1,200
.12 Branch 2
(.30) $ 900
.06 Branch 3
(.35) $ 900
.21 Branch 4
(.60)
60 $450 (.40) $ 600
-$900 2 .24 Branch 5
(.25) $ 300
.15 Branch 6
(.10) $ 500
.02 Branch 7
(.20)
.20 -$600 3 (.50) -$ 100
.10 Branch 8
(.40) -$ 700
.08 Branch 9
Year 1 Year 2
4-21
 Project NPV Based on
Probability Tree Usage
z
The probability NPV = i= 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 + Rf )2
1
return.
- ICO
4-22
 NPV for Each Cash-Flow
Stream at 5% Risk-Free Rate
(.10) $2,200
$ 2,238.32
(.20)
.20 $1,200 1 (.60) $1,200
$ 1,331.29
(.30) $ 900
$ 1,059.18
(.35) $ 900
$ 344.90
(.60)
60 $450 (.40) $ 600
-$900 2 $ 72.79
(.25) $ 300
-$ 199.32
(.10) $ 500
-$ 1,017.91
(.20)
.20 -$600 3 (.50) -$ 100
-$ 1,562.13
(.40) -$ 700
-$ 2,106.35
Year 1 Year 2
4-23
 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
4-24
 Calculating the Variance
of the Net Present Value
NPVi P(1,2) (NPVi - NPV )2[P(1,2)]
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 = $1,031,800.31
4-25
 Summary of the Decision
Tree Analysis
Decision Tree Analysis
(P) (NPV)
Joint Probability Formula Branch NPV of each branch (P) x (NPV) (P) x [(NPV - NPV-bar)^2]
Risk-free 2200
5.00% 0.10 0.02 =$D$11*G9 1 $2,238.32 $44.77 $101,730.16
1200 1200
0.20 0.60 0.12 =$D$11*G11 2 $1,331.29 $159.76 $218,149.33
900
0.30 0.06 =$D$11*G13 3 $1,059.18 $63.55 $69,491.16

900
0.35 0.21 =$D$18*G16 4 $344.90 $72.43 $27,504.76
-900 450 600
0.60 0.40 0.24 =$D$18*G18 5 $72.79 $17.47 $1,935.19
300
0.25 0.15 =$D$18*G20 6 ($199.32) ($29.90) $4,985.70

500
0.10 0.02 =$D$25*G23 7 ($1,017.91) ($20.36) $20,036.30
-600 -100
0.20 0.50 0.1 =$D$25*G25 8 ($1,562.13) ($156.21) $238,741.04
-700
0.40 0.08 =$D$25*G27 9 ($2,106.35) ($168.51) $349,228.13

1.00 =SUM(I9:I27) -17.01 1015.78

Expected NPV Standard Deviation
'NPV-bar'

Refer to “VW13E-13b.xlsx” on tab ‘Decision Tree’

4-26
 Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78

The expected NPV = -$ 17.01

4-27
 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
 Allows the firm to delay undertaking a project
(reduces uncertainty via new information).
4-28
 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

4-29
 Previous Example with
Project Abandonment
(.10) $2,200
Assume that
(.20)
.20 $1,200 1 (.60) $1,200 this project
(.30) $ 900 can be
abandoned at
(.35) $ 900 the end of the
(.60)
60 $450 (.40) $ 600 first year for
-$900 2
(.25) $ 300 $200.
$200
(.10) $ 500 What is the
(.20)
.20 -$600 3 (.50) -$ 100 project
(.40) -$ 700 worth?
worth
Year 1 Year 2
4-30
 Project Abandonment
(.10) $2,200
Node 3:
3
(.20)
.20 $1,200 1 (.60) $1,200
(.30) $ 900 (500/1.05)(.1)+
500
(-100/1.05)(.5)+
-100
(.35) $ 900 (-700/1.05)(.4)=
-700
(.60)
60 $450 (.40) $ 600
-$900 2
(.25) $ 300 ($476.19)(.1)+
-($ 95.24)(.5)+
(.10) $ 500
-($666.67)(.4)=
(.20)
.20 -$600 3 (.50) -$ 100
(.40) -$ 700 -($266.67)
Year 1 Year 2
4-31
 Project Abandonment
(.10) $2,200
The optimal
(.20)
.20 $1,200 1 (.60) $1,200 decision at the
(.30) $ 900 end of Year 1
is to abandon
(.35) $ 900 the project for
(.60)
60 $450 (.40) $ 600 $200.
$200
-$900 2
(.25) $ 300 $200 >
(.10) $ 500 -($266.67)
(.20)
.20 -$600 3 (.50) -$ 100 What is the
(.40) -$ 700 “new” project
value?
Year 1 Year 2
4-32
 Project Abandonment
(.10) $2,200
$ 2,238.32
(.20)
.20 $1,200 1 (.60) $1,200
$ 1,331.29
(.30) $ 900
$ 1,059.18
(.35) $ 900
$ 344.90
(.60)
60 $450 (.40) $ 600
-$900 2 $ 72.79
(.25) $ 300
-$ 199.32

(.20)
.20 -$400* 3 (1.0) $ 0
-$ 1,280.95
*-$600 + $200 abandonment
Year 1 Year 2
4-33
 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
4-34 * For “True” Project considering abandonment option
 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.

4-35
 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
4-36
 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.
4-37
 Simulation Approach
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:
OF OCCURRENCE
PROBABILITY

INTERNAL RATE OF RETURN (%)

4-38
 Contribution
Contribution to
to Total
Total Firm
Firm Risk:
Risk:
Firm-Portfolio
Firm-Portfolio Approach
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.
diversification
4-39
 Determining
Determining the
the Expected
Expected
NPV
NPV for
for aa Portfolio
Portfolio of
of Projects
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.
4-40
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
m m
P = 
k=1
jk
j=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
4-41 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
4-42