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## PowerPoint Slideshow about 'Risk Topics and Real Options in Capital Budgeting' - palila

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Presentation Transcript

Cash Flows as Random Variables

- Risk is chance that a random variable will take on a value significantly different from the expected value
- In capital budgeting the estimate of each future period's cash flow is a random variable
- The NPV and IRR of any project are random variables with expected values and variances that reflect risk
- Thus, the actual value is likely to be different than the mean
- The amount the actual value is likely to differ from the expected is related to the variance or standard deviation

The Importance of Risk in Capital Budgeting

- Thus far we've viewed cash flows as point estimates
- However, since a project's actual cash flows are estimates we could be making a wrong decision by using point estimates for NPV and IRR
- The riskiness of a project's cash flows must be considered when deciding upon a project

The Importance of Risk in Capital Budgeting

- Risk Aversion
- All other things equal, we prefer less risky capital projects to those with more risk
- Changing the Nature of the Company
- A company is a portfolio of projects
- Thus, if a firm undertakes new projects while ignoring risk, it could change its fundamental risk characteristics
- A company adopting riskier projects than it used to will become a riskier company
- Will lead to a higher beta
- Can generally lead to a stock price reduction

Scenario/Sensitivity Analysis

- Involves selecting a worse, most likely and best case for each cash flow
- Most likely is the cash flow estimate we've worked with before
- Recalculate the project's NPV (or IRR) under each scenario
- Evaluating a number of scenarios gives a subjective feel for the variability of the NPV to changes in our assumptions
- Referred to as sensitivity analysis

Computer (Monte Carlo) Simulation

- Involves making assumptions about the shape of each future cash flow
- A computer is used to quickly determine random observations for each uncertain cash flows and determine numerous possible outcomes (1000s)
- Computer then simulates project by constructing a probability distribution of the project's NPV (IRR)
- Drawbacks
- Probability distributions have to be estimated subjectively
- Project cash flows tend to be positively correlated—hard to estimate the extent of that correlation
- Interpretation of results is subjective

Decision Tree Analysis

- Decision Tree analysis lets us approximate the NPV distribution if we can estimate the probability of certain events within the project
- A decision tree is an expanded time line which branches into alternate paths whenever an event can turn out more than one way
- The place at which branches separate is called a node
- Any number of branches can emanate from a node but the probabilities must sum to 1.0 (or 100%)
- A path represents following the tree along a branch
- Evaluating a project involves calculating NPVs along all possible paths and developing a probability distribution

Real Options

- An option is the ability or right to take a certain course of action
- Real options represent those that exist in a real physical, business sense
- Real options frequently occur in capital budgeting
- Generally increase a project's expected NPV
- This increase is often a good estimate of the option's value

Real Options

- For example, suppose a sports apparel company sells jackets/sweatshirts with professional football team insignias and it depends on bank credit to support routine operations
- Firm usually has a bank loan of $1 million, but if local professional team makes it to the Super Bowl demand is expected to double and the firm expects to need $2 million in bank credit
- Manager doesn't want to borrow the extra $1M--what if football team doesn't make it to Super Bowl?
- Company can pay a consultant fee to bank in which the bank agrees to lend firm the money if the company wants it
- Commitment fees usually about 1/4% annually of he unborrowed, but committed, amount (or 1/4% x $1M = $2,500)
- Bank charges normal interest rate on money once it is borrowed
- This arrangement gives the business the ability to take advantage of the potential increase, because it has the right (but not the obligation) to borrow the extra $1M

The Abandonment Option

- If a project is undertaken and eventually experiences poor demand, it is likely that the project will be abandoned
- The facilities and equipment (or the cash flows generated from their sale) must be expected to have better use elsewhere

Valuing Real Options

- Real options are generally worth more than their impact on expected NPV because they generally reduce risk
- However, difficult to place a quantitative value to the risk reduction
- An Approach Through Rate of Return
- Lower risk should be associated with a lower rate of return in NPV calculations—leads to a higher NPV calculation
- Difficulty lies with choosing the right risk-adjusted rate
- The Risk Effect is Tricky
- The value of real options has to be considered on a case-by-case basis

Designing for Real Options

- Abandonment option—can increase expected NPV and lower risk
- Contractual obligations can make abandonment tough
- Expansion options
- Frequently require little or no early commitment and should be planned whenever possible
- Investment timing options
- Allow a firm to delay an investment until it's sure about other relevant issues
- Flexibility options
- Allow company ability to respond more easily to changes in business conditions

Incorporating Risk Into Capital Budgeting

- The cost of capital (k) plays a key role in both NPV and IRR
- For NPV, k is used as the discount rate
- A higher k leads to a lower NPV, reducing the chance of project acceptance
- For IRR, IRR is compared to k
- A higher k leads to a lower chance of project acceptance

Incorporating Risk Into Capital Budgeting

- Riskier Projects Should Be Less Acceptable
- Idea is to make risky projects less acceptable than others with similar expected cash flows
- Using a higher, risk-adjusted rate for risky projects lowers their chance of acceptance
- The Starting Point for Risk-Adjusted Rates
- The current situation of the firm (in terms of risk) is the starting point

Incorporating Risk Into Capital Budgeting

- Relating Interest Rates to Risk
- Interest rates are made up of a base rate plus a risk premium
- Investors demand a higher risk premium and interest rate if they are to bear more risk
- In capital budgeting the company is the investor, thus the firm's cost of capital is used as the discount rate for an average risk project
- Choosing the Risk-Adjusted Rate for Various Projects
- Somewhat of an arbitrary process, subjective

Incorporating Risk Into Capital Budgeting

- Some logic can aid in the process
- Replacement projects involved replacing something the firm has already been doing
- Thus, the firm's cost of capital is nearly always appropriate for this type of project
- Expansion projects are more risky than the current level, but not much more
- A rule of thumb is to add 1-3% points to the cost of capital
- New venture projects usually involve much more risk than current projects
- Choosing risk-adjusted rate is difficult and arbitrary

Estimating Risk-Adjusted Rates Using CAPM

- The Project as a Diversification
- If the firm is viewed as a collection of projects, a new venture diversifies the company
- A new venture also diversifies the investment portfolios of the firm's shareholders
- Diversifiable and Non-Diversifiable Risk for Projects
- Projects have two levels of diversifiable risk because they are effectively in two portfolios at once
- Some risk is diversified away within the firm's portfolio of projects
- Some risk is diversified away by the shareholders' investment portfolios
- The remaining risk is known as systematic risk

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 project
- SML: kx = kRF + (KM - kRF)bX
- Where bX is beta, or the measure of a company's systematic risk
- If a capital budgeting project is viewed as a business in a particular field, it may make sense to use a beta common to that field in the SML to estimate a risk-adjusted rate for analysis of the project
- This method is most appropriate when an independent, publicly traded firm can be found that is in the same business as the new venture (pure play firm)
- Pure play firm must be solely in the business of the new venture

Problems with the Theoretical Approach

- The biggest problem is finding a pure play firm from which to obtain an appropriate beta
- Betas of conglomerates are influenced by other divisions (in other industries)
- Thus, we have to estimate betas by using firms in similar (but not exactly) the same businesses
- Reduces the credibility of the technique
- Another problem is that systematic risk may not be the only risk that is important
- If total risk is what's really important, it would lead to an even higher risk-adjusted rate

Projects in Divisions—The Accounting Beta Method

- If a pure play division is found within a corporation, may be able to estimate the beta of that division using the accounting beta method
- Develop a beta for the division from its accounting records (rather than stock price data)
- Regress historical divisional return on equity against the return on a major stock market index
- Slope of the regression line represents the division's beta

A Final Comment on Risk in Capital Budgeting

- Virtually every firm uses capital budgeting techniques but only a few overtly try to incorporate risk
- Business managers do recognize risk but they do it judgmentally

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