Practical financial management lasher 7th ed chapter 012

Chapter 12 Risk Topics and Real Options in Capital Budgeting and Cash Flow Estimation... The Importance of Risk in Capital Budgeting Until now we have viewed cash flows as point estimat

Chapter 12 Risk Topics and Real Options in Capital Budgeting and Cash Flow Estimation

Cash Flows as Random Variables

“Risk” in every day usage: the probability that something bad will happen

“Risk” in financial theory: Associated

with random variables and their

probability distributions

Cash Flows as Random Variables

Risk – the chance that a random variable will take on a value significantly different from the expected value

– In capital budgeting the future period's cash flow estimate is a random variable

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Figure 12-1 The Probability Distribution of a Future Cash

Flow as a Random Variable

Cash Flows as Random Variables

The NPV and IRR are random variables with their own probability distributions

– Actual value may be different than the mean – The amount the actual value is different

from expected is related to the variance or standard deviation

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Figure 12-2 Risk in Estimated

Cash Flows

The Importance of Risk in

Capital Budgeting

Until now we have viewed cash flows as point

estimates – a single number rather than a range of possibilities

Actual cash flows are estimates, a wrong decision could be made using point estimates for NPV and IRR

The riskiness of a project's cash flows must be

considered

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Figure 12-3 Project NPVs Reflecting

Risky Cash Flows

The Importance of Risk in Capital

Budgeting

Risk Aversion

Changing the Nature of a Company

– A company is a portfolio of projects

– Ignoring risk when undertaking new projects can change the firm’s overall risk

characteristics

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Concept Connection Example 12-1

Scenario Analysis

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Concept Connection Example 12-1

Scenario Analysis

Decision Tree Analysis

Decision Tree: A graphic representation of a project in which certain events have multiple outcomes

Decision Tree Analysis – Develops a

probability distribution of NPV given the

probabilities of certain events within the project

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Computer (Monte Carlo) Simulation

Assume separate probability distribution for each cash flow Computer draws observation from each and calculates NPV Sort outcomes into histogram of probability distribution of NPV (next slide)

Drawbacks

– Probability distributions are difficult to estimate

– Cash flows tend to be correlated

– Interpretation of results is subjective

Figure 12-4 Results of Monte Carlo

Simulation for NPV

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Figure 12-5 A Simple Decision Tree

Concept Connection Example 12-2

Decision Tree Analysis

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The Wing Foot Shoe Company is considering a new running shoe A market study indicates a 60% probability that demand will be good and a 40%

chance that it will be poor

C0 is $5M Cash inflows are estimated at $3M

per year for three years at full manufacturing capacity

if demand is good, but just $1.5M per year if it’s poor Wing Foot’s cost of capital is 10%

Develop a rough probability distribution for NPV

Concept Connection Example 12-2

Decision Tree Analysis

A decision tree diagram and NPVs along each path are:

$1.5M

$1.5M

$1.5M ($5M)

$3M

$3M

$3M

3 2

1 0

The expected NPV is:

The decision tree explicitly calls out the fact that

a big loss is quite possible,

Figure 12-6 A More Complex

Decision Tree

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Concept Connection Example 12-3 More

Complex Decision Trees

Wing Foot now feels there are two possibilities along the upper branch

If first year demand is good, there’s a 30% chance it will

be excellent in the second and third years, and a $1 million

factory expansion will generate cash inflows of $5 million in

Concept Connection Example 12-3 More

Complex Decision Trees

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The NPV for the new upper path is

Concept Connection Example 12-3 More

Complex Decision Trees

Concept Connection Example 12-3 More

Complex Decision Trees

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Concept Connection Example 12-3 More

Complex Decision Trees

The project’s probability distribution expected return are

as follows

Real Options

An option is the right or ability to take a certain course of action

A real option is a course of action that usually

– Improves financial results under certain

conditions

– Exists in a real, physical business sense

– Frequently occurs in capital budgeting

– Generally increases a project's expected NPV

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The Abandonment Option

A poorly performing project can sometimes be abandoned

– Usually by redeploying project resources to another use

Avoids continuing losses along a decision tree path

It usually takes planning early in a project’s life

to preserve an abandonment option

Valuing Real Options

Real Options usually

– have definite costs early in projects

– Create additional income along only one path

– The chance of more income increases NPV

An option’s value is at least the increase in NPV less the option’s cost

– But the real option may be worth more if it also reduces project risk (e.g abandonment )

Valuing Real Options

The Risk Effect is Tricky –

– Not all real options have a risk effect

– To lower risk an option has to reduce a potential loss not make a success better

– A case by case analysis is necessary

An Approach Through Rate of Return

– If lower risk is associated with a lower rate of return

Designing Real Options into Projects

Abandonment option

– Usually increase NPV and lower risk

– Contract obligations can make abandonment tough

Expansion options

– Often require little or no early commitment

– Should be planned in whenever possible

Investment timing options

– Permit delaying investment until more certain about surrounding issues

Flexibility options

– Preserve ability to respond to changing business conditions

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Incorporating Risk Into

– For IRR– Compare IRR to k

A higher k leads to a lower chance that IRR>k reducing probability of project acceptance

The cost of capital (k) plays a key role in both NPV and IRR

Incorporating Risk Into

Capital Budgeting

Riskier Projects Should Be Less Acceptable – Using a higher, risk-adjusted rates for risky projects lowers their chance of acceptance

The Starting Point for Risk-Adjusted Rates is the firm’s current risk level reflected in its cost

of capital

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Incorporating Risk Into

Capital Budgeting

Relating Interest Rates to Risk

– Interest rates are comprised of a base rate plus a risk premium

– Investors demand a higher risk premiums  higher interest rates

if they are to bear more risk

Incorporating Risk Into

Capital Budgeting

Choosing the Risk-Adjusted Rate for Various Projects

– An arbitrary, subjective process

Three categories of increasing risk

– Replacements – low risk, use cost of capital

– Expansion projects - slightly more risky than the current level

– New ventures – generally involve a lot more risk

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Estimating Risk-Adjusted Rates

Using CAPM

The project as a diversification

– If viewed as a collection of projects, a new venture diversifies the firm

– A new venture also diversifies the

stockholders’ investment portfolios

Estimating the Risk-Adjusted Rate

Through Beta

The Security Market Line (SML) can be used to determine

a risk-adjusted rate for a new venture

SML: kx = kRF + (kM - kRF) bX

– bX = beta = the measure of a company's systematic risk

If a project is viewed as a business in a particular field, use

a beta common to that field to estimate a risk-adjusted rate for project analysis

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Estimating Risk-Adjusted Rates

Using CAPM

The project as a diversification

Diversifiable and non-diversifiable risk for projects

– Projects have two levels of diversifiable risk

Some risk diversified away within the firm's

Figure 12-7 Components of Project Risk

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Concept Connection Example 12-6

Risk-Adjusted Rates - SML

Orion Inc makes radio communications equipment

beta = 1.1 cost of capital = 8%

Considering a venture into risky military radios

Military radio market is dominated by

Milrad Inc - 60% market share, beta = 1.4

Antex Radio Corp - 20% market share, beta = 2.0

Both make only military radios

kM = 10% , kRF = 5%

C0 = $10M, Ci= $3M n = 5 years

Should Orion undertake the project?

Concept Connection Example 12-6

at best.

Problems with the Theoretical Approach

It is often difficult to find a pure play firm from which to obtain an appropriate beta

– If a pure play division is found within a corporation, estimate the beta of that division using the

accounting beta method

Systematic risk may not be only important risk

– If total risk is important, an even higher

risk-adjusted rate would be appropriate

Certainty Equivalents (CE)

For every cash flow management develops a lower risk free (certain) figure that is as attractive as the

forecast risky figure

– Then calculate a risk adjusted NPV or IRR with those cash flows

Alternatively choose a CE factor (0< 1) for each cash flow and multiply

– CE factors generally decline as they proceed

further into the future

A Final Comment on Risk in Capital

Budgeting

Virtually every firm of any size uses

capital budgeting techniques

– But few explicitly include risk

Business managers do recognize risk but they do it through subjective

judgments