Risk Topics and Real Options in Capital Budgeting

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# Risk Topics and Real Options in Capital Budgeting - PowerPoint PPT Presentation

Risk Topics and Real Options in Capital Budgeting. Chapter 11. © 2003 South-Western/Thomson Learning. Cash Flows as Random Variables. Risk is chance that a random variable will take on a value significantly different from the expected value

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### Risk Topics and Real Options in Capital Budgeting

Chapter 11

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
• 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