Ceralvo, Robbie Rae C.

Risk Analysis, Real Options and Capital Budgets

Risk Analysis reflected in capital budgeting decisions. Risk involving stand alone risk,

corporate risk and market risk greatly affects the decision making. Taking a project with a high

stand alone or corporate risk will not affect the firm’s beta. However, if the project has high

stand-alone risk and if its returns are highly correlated with returns on the firm’s other assets

then the project will have high degree of all type of risks. There are methods to measure the

stand-alone risk. Sensitivity analysis measures the percentage change in NPV resulting from a

given percentage change in an input variable, other things held constant. If we were comparing

two projects, the one with steeper sensitivity lines would be riskier, other things held constant,

because relatively small changes in the input variables, would produce large changes in NPV.

Real options are the rights but not the obligation to take some future actions. These are not

passive investments which distinguish it from the financial options. Real options include

expansions where the project can be expanded if demands turns out to be stronger than

expected, abandonment where the project can be shutdown, investment timing where the

project can be postponed, output flexibility where the output can be changed in market condition

and input flexibility where the input used in the production process can be changed if input price

changed. We using capital budgeting techniques to make decision on real options

1. How to estimate optimal capital budget?

2. In a growth option, if the firm fails to consider growth options, what would be the effect

on project’s NPV?

3. How do flexibility options affect project’s NPV and risk?