Professional Documents
Culture Documents
4-1
Risk and Managerial
Options in Capital Budgeting
4-2
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
4-3
Probability Distribution
of Year 1 Cash Flows
Proposal A
.40
Probability
.25
.05
4-8
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
4-9
Probability Distribution
of Year 1 Cash Flows
Proposal B
.40
Probability
.25
.05
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
4-17
Probability Tree Approach
4-23
Actual NPV Solution Using
Your Financial Calculator
4-24
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
4-25
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
Variance = $1,031,800.31
4-27
Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
4-28
Simulation Approach
4-29
Simulation Approach
Factors we might consider in a model:
Market analysis
Market size, selling price, market
Combination of
Proposal A Proposal B Proposals A and B
CASH FLOW
4-37
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).
4-38
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
4-39
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
4-40
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
4-41
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
4-42
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
4-43 * For “True” Project considering abandonment option