Professional Documents
Culture Documents
14-*
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-*
Probability Distribution
of Year 1 Cash Flows
Proposal A
.40
Probabilit
.25
y
.05
14-*
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-*
Probability Distribution
of Year 1 Cash Flows
Proposal B
.40
Probabilit
.25
y
.05
Cash Flow
Projects are more
likely to have
continuous, rather
than discrete ($)
distributions.
1 2
14-* 3
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-*
Probability Tree Approach
Year 1
14-*
Probability Tree Approach
(.10)
Each node in
(.20) $2,200
(.60)
1 Year 2
$1,200 $1,200
(.30) $ represents a
900 branch of our
(.35) $ probability
(.60) 900
(.40) $ tree.
-$900 $450 2
600 $
(.25) The
300 probabilities
(.10) $
500 are said to be
(.20) - (.50) -$ 100
3 conditional
$600 (.40) -$ 700 probabilities.
Year 1 Year 2
14-*
Joint Probabilities [P(1,2)]
(.10)
.02 Branch 1
(.20) $2,200
(.60)
1 .12 Branch 2
$1,200 $1,200
(.30) $ .06 Branch 3
900
(.35) $ .21 Branch 4
(.60) 900
(.40) $
-$900 2 .24 Branch 5
$450 600 $
(.25) .15 Branch 6
300
(.10) $ .02 Branch 7
(.20) - 500
(.50) -$ 100 .10 Branch 8
3
$600 (.40) -$ 700 .08 Branch 9
Year 1 Year 2
14-*
Project NPV Based on
Probability Tree Usage
z
The probability NPV = iΣ= 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.
-
14-*
ICO
NPV for Each Cash-Flow
Stream at 5% Risk-Free Rate
(.10)
$ 2,238.32
(.20) $2,200
(.60)
1 $ 1,331.29
$1,200 $1,200
(.30) $ $ 1,059.18
900
(.35) $ $ 344.90
(.60) 900
(.40) $
-$900 2 $ 72.79
$450 600 $
(.25) -$ 199.32
300
(.10) $ -$ 1,017.91
(.20) - 500
(.50) -$ 100 -$ 1,562.13
3
$600 (.40) -$ 700 -$ 2,106.35
Year 1 Year 2
14-*
NPV on the Calculator
Remember, we can
use the cash flow
registry to solve these
NPV problems quickly
and accurately!
14-*
Actual NPV Solution Using
Your Financial Calculator
14-*
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
14-*
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-*
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-*
Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV = -$ 17.01
14-*
Simulation Approach
14-*
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
14-* ●Operating costs and fixed costs
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-*
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:
OCCURRENCE
PROBABILITY
OF
Combination of
Proposal A Proposal Proposals A and
B B
FLOW
CASH
14-*
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).
14-*
Previous Example with
Project Abandonment
(.10)
Assume that
(.20) $2,200
(.60)
1 this project
$1,200 $1,200
(.30) $ can be
900 abandoned at
(.35) $ the end of the
(.60) 900
(.40) $ first year for
-$900 $450 2
600 $
(.25) $200.
300 What is the
(.10) $
500 project
(.20) - (.50) -$ 100
3 worth?
$600 (.40) -$ 700
Year 1 Year 2
14-*
Project Abandonment
(.10)
Node 3:
(.20) $2,200
(.60)
1 (500/1.05)(.1)+
$1,200 $1,200
(.30) $ (-100/1.05)(.5)+
900 (-700/1.05)(.4)=
(.35) $
(.60) 900
(.40) $ ($476.19)(.1)+
-$900 $450 2
600 $
(.25) -($ 95.24)(.5)+
300 -($666.67)(.4)=
(.10) $
500 -($266.67)
(.20) - 3
(.50) -$ 100
$600 (.40) -$ 700
Year 1 Year 2
14-*
Project Abandonment
(.10)
The optimal
(.20) $2,200
(.60)
1 decision at the
$1,200 $1,200
(.30) $ end of Year 1 is
900 to abandon the
(.35) $ project for
(.60) 900
(.40) $ $200.
-$900 $450 2
600 $
(.25) $200 >
300 -($266.67)
(.10) $
(.20) - 500
(.50) -$ 100 What is the
3
$600 (.40) -$ 700 “new” project
value?
Year 1 Year 2
14-*
Project Abandonment
(.10)
$ 2,238.32
(.20) $2,200
(.60)
1 $ 1,331.29
$1,200 $1,200
(.30) $ $ 1,059.18
900
(.35) $ $ 344.90
(.60) 900
(.40) $
-$900 2 $ 72.79
$450 600 $
(.25) -$ 199.32
300
(.20) - 3
(1.0) $ -$ 1,280.95
$400* 0
*-$600 + $200 abandonment
Year 1 Year 2
14-*
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