14 Risk and Managerial (Real) Options in Capital Budgeting

Lecture Handouts for Chapter 14

Chapter 14 is covered in lectures 24, 25, and 26.

Project Risk
The risk of an investment project can be viewed as the variability of its cash
flows from those that are expected.

Probability Distribution of Possible Cash Flows

The possible outcomes for an investment project can be expressed in the form
of probability distributions of possible cash flows.

Standard Deviation
Given a cash-flow probability distribution, we can express risk quantitatively as
the standard deviation of the distribution.

Coefficient of Variation (CV)

A measure of the relative risk of a distribution is the coefficient of variation (CV).
Mathematically, it is defined as the ratio of the standard deviation of a
distribution to the expected value of the distribution.

Probability Tree and Simulation Method

One approach to the evaluation of risky investments is the direct analysis of
the probability distribution of possible net present values of a project
calculated at the risk-free rate. A probability tree or simulation method may be
used to estimate the expected value and standard deviation of the distribution.
Management can then use this information to determine the probability that
the actual net present value will be lower than some amount, such as zero.

Use of Probability Distribution Information

The probability that a projects internal rate of return will be less than the risk-
free rate is equal to the probability that the projects net present value will be
less than zero, where the risk-free rate is used in discounting. If we view an
opportunity loss as any return less than the risk-free return, then the

1
 14 Risk and Managerial (Real) Options in Capital Budgeting

likelihood of an NPV less than zero can be interpreted as the chance of

incurring an opportunity loss if the project is accepted.

Contribution to Total Firm Risk: Firm-Portfolio Approach

Investment projects can also be judged with respect to their contribution to
total firm risk, which implies a firm-portfolio approach to risk assessment.

By diversifying into projects not having high degrees of correlation with existing
assets, a firm is able to reduce the standard deviation of its probability
distribution of possible net present values relative to the expected value of the
distribution. The correlations between pairs of projects prove to be the key
ingredients in analyzing risk in a firm-portfolio context.

Managerial (Real) Options

Often managerial options are important considerations in capital budgeting.
The term simply means the flexibility that management has to alter a
previously made decision.

An investment projects worth can be viewed as its traditionally calculated net

present value together with the value of any managerial option(s). The greater
the uncertainty surrounding the use of an option, the greater the value of this
option can be.

Managerial options include the option to expand (contract), the option to

abandon, and the option to postpone. Consideration of these various options
can sometimes turn a reject decision otherwise made in evaluating a capital
budgeting project into an accept decision and an accept decision into a
decision to postpone.

2
 14 Risk and Managerial (Real) Options in Capital Budgeting

Questions
1. Why should we be concerned with risk in capital budgeting? Why not just
work with the expected cash flows as we did in Chapter 13?

2. Is the standard deviation an adequate measure of risk? Can you think of a

better measure?

3. How do you go about standardizing the dispersion of a probability

distribution to make generalizations about the risk of a project?

4. Risk in capital budgeting can be judged by analyzing the probability

distribution of possible returns. What shape distribution would you expect to
find for a safe project whose returns were absolutely certain? For a very risky
project?

5. If project A has an expected value of net present value of $200 and a

standard deviation of $400, is it more risky than project B, whose expected
value is $140 and standard deviation is $300? Explain.

6. In a probability tree approach to project risk analysis, what are initial,

conditional, and joint probabilities?

7. Why should the risk-free rate be used for discounting cash flows to their
present value when evaluating the risk of capital investments?

8. What are the benefits of using simulation to evaluate capital investment

projects?

9. What role does the correlation between net present values play in the risk of
a portfolio of investment projects?

The risk of an investment project can be viewed as the variability of its

cash flows from those that are expected.
The possible outcomes for an investment project can be expressed in the
form of probability distributions of possible cash flows. Given a cash-flow
probability distribution, we can express risk quantitatively as the
standard deviation of the distribution.
A measure of the relative risk of a distribution is the coefficient of
variation (CV). Mathematically, it is defined as the ratio of the standard
deviation of a distribution to the expected value of the distribution.
One approach to the evaluation of risky investments is the direct
analysis of the probability distribution of possible net present values of a
project calculated at the risk-free rate. A probability tree or simulation

3
 14 Risk and Managerial (Real) Options in Capital Budgeting

method may be used to estimate the expected value and standard

deviation of the distribution. Management can then use this information
to determine the probability that the actual net present value will be
lower than some amount, such as zero.
The probability that a projects internal rate of return will be less than
the risk-free rate is equal to the probability that the projects net present
value will be less than zero, where the risk-free rate is used in
discounting. If we view an opportunity loss as any return less than the
risk-free return, then the likelihood of an NPV less than zero can be
interpreted as the chance of incurring an opportunity loss if the project is
accepted.
Investment projects can also be judged with respect to their contribution
to total firm risk, which implies a firm-portfolio approach to risk
assessment.
By diversifying into projects not having high degrees of correlation with
existing assets, a firm is able to reduce the standard deviation of its
probability distribution of possible net present values relative to the
expected value of the distribution. The correlations between pairs of
projects prove to be the key ingredients in analyzing risk in a firm-
portfolio context.
Often managerial options are important considerations in capital
budgeting. The term simply means the flexibility that management has to
alter a previously made decision.
An investment projects worth can be viewed as its traditionally
calculated net present value together with the value of any managerial
option(s). The greater the uncertainty surrounding the use of an option,
the greater its value.
Managerial options include the option to expand (contract), the option to
abandon, and the option to postpone. Consideration of these various
options can sometimes turn a reject decision otherwise made in
evaluating a capital budgeting project into an accept decision and an
accept decision into a decision to postpone.

10. What is meant by dominance in a portfolio sense?

11. Under a portfolio approach how would we know whether particular projects
were accepted or rejected?

12. What are managerial options and why are they important?

13. In general terms, what determines the value of a managerial option?

4
 14 Risk and Managerial (Real) Options in Capital Budgeting

14. Name the various types of managerial option, and describe how they differ
from one another.

Answers
Refer the manual.

5
 14 Risk and Managerial (Real) Options in Capital Budgeting

Problems
1. George Gau, Inc., can invest in one of two mutually exclusive, one-year
projects requiring equal initial outlays. The two proposals have the following
discrete probability distributions of net cash inflows for the first year:

a. Without calculating a mean and a coefficient of variation, can you select the
better proposal, assuming a risk-averse management?

b. Verify your intuitive determination.

2. Smith, Jones, and Nguyen, Inc., is faced with several possible investment
projects. For each, the total cash outflow required will occur in the initial
period. The cash outflows, expected net present values, and standard
deviations are given in the following table. All projects have been discounted at
the risk-free rate, and it is assumed that the distributions of their possible net
present values are normal.

a. Are there some projects that are clearly dominated by others with respect to
expected value and standard deviation? With respect to expected value and
coefficient of variation?

b. What is the probability that each of the projects will have a net present value
less than zero?

6
 14 Risk and Managerial (Real) Options in Capital Budgeting

3. The probability distribution of possible net present values for project X has
an expected value of $20,000 and a standard deviation of $10,000. Assuming a
normal distribution, calculate the probability that the net present value will be
zero or less, that it will be greater than $30,000, and that it will be less than
$5,000.

4. Xonics Graphics, Inc., is evaluating a new technology for its reproduction

equipment. The technology will have a three-year life, will cost $1,000, and will
have an impact on cash flows that is subject to risk. Management estimates
that there is a fifty-fifty chance that the technology will either save the
company $1,000 in the first year or save it nothing at all. If nothing at all,
savings in the last two years would be zero as well. Even here there is some
possibility that in the second year an additional outlay of $300 would be
required to convert back to the original process, for the new technology may
decrease efficiency.

Management attaches a 40 percent probability to this occurrence if the new

technology bombs out in the first year. If the technology proves itself in the
first year, it is felt that second-year cash flows will be $1,800, $1,400, and
$1,000, with probabilities of 0.20, 0.60, and 0.20, respectively. In the third
year, cash flows are expected to be either $200 greater or $200 less than the
cash flow in period 2, with an equal chance of occurrence. (Again, these cash
flows depend on the cash flow in period 1 being $1,000.)

a. Set up a tabular version of a probability tree to depict the cash-flow

possibilities, and the initial, conditional, and joint probabilities.

b. Calculate a net present value for each of the three-year possibilities (that is,
for each of the eight complete branches in the probability tree) using a risk-free
rate of 5 percent.

c. Calculate the expected value of net present value for the project represented
in the probability tree.

d. What is the risk of the project?

5. The Flotsam and Jetsam Wreckage Company will invest in two of three
possible proposals, the cash flows of which are normally distributed. The
expected net present value (discounted at the risk-free rate) and the standard
deviation for each proposal are given as follows:

7
 14 Risk and Managerial (Real) Options in Capital Budgeting

Assuming the following correlation coefficients for each possible two-project

combination, which combination dominates the others?

6. The Plaza Corporation is confronted with various combinations of risky

investments.

a. Plot the above portfolios.

b. Which combinations dominate the others?

7. The Bertz Merchandising Company uses a simulation approach to judge

investment projects. Three factors are employed: market demand, in units;
price per unit minus cost per unit (on an after-tax basis); and investment
8
 14 Risk and Managerial (Real) Options in Capital Budgeting

required at time 0. These factors are felt to be independent of one another. In

analyzing a new fad consumer product with a one-year product life, Bertz
estimates the following probability distributions:

a. Using a table of random numbers or some other random process, simulate

20 or more trials of these three factors, and compute the internal rate of return
on this one-year investment for each trial.

b. Approximately, what is the most likely return? How risky is the project?

8. The Bates Pet Motel Company is considering opening a new branch location.
If it constructs an office and 100 pet cages at its new location, the initial outlay
will be $100,000, and the project is likely to produce net cash flows of $17,000
per year for fifteen years, after which the leasehold on the land expires and the
project is left with no residual or salvage value. The companys required rate of
return is 18 percent. If the location proves favorable, Bates Pet Motel will be
able to expand by another 100 cages at the end of four years. This second-
stage expansion would require a $20,000 outlay. With the additional 100 cages
installed, incremental net cash flows of $17,000 per year for years 5 through
15 would be expected. The company believes there is a fifty-fifty chance that
the location will prove to be a favorable one.

a. Is the initial project acceptable? Why?

b. What is the value of the option to expand? What is the project worth with
this option? Is the project now acceptable? Why?

Solutions
Refer the manual.