Chapter 14

Risk and Managerial

(Real) Options in
Capital Budgeting
Riskiness of an Investment
Project
It is the variability of its
cash flows from those
that are expected.
The greater the
variability, the riskier
the project is said to be.
Total Project Risk
If investors and creditors
are risk averse, it is
necessary for management
to incorporate the risk of
an investment proposal
into its analysis of the
proposals worth.
Probability Tree Approach
It is a graphic or tabular
approach for organizing the
possible cash-flow streams
generated by an investment.
The likely future cash flows of a
project is specified as they
relate to the outcomes in
previous periods.
Simulation Approach
This mean testing the
possible results of an
investment proposal before
it is accepted.
The testing itself is based
on a model coupled with
probabilistic information.
Firm-Portfolio Approach
If a firm adds a project whose
future cash flows are likely to
be highly correlated with those
of existing assets, the total risk
of the firm will increase more
than if it adds a project that
has a low degree of correlation
with existing assets.
Firm-Portfolio Approach
Given that reality, a firm might
wish to seek out projects that
could be combined to reduce
relative firm risk.
The combining of projects in a
way that will reduce risk is
known as diversification.
Firm-Portfolio Approach
By accepting projects with
relatively low degrees of
correlation with existing
projects, a firm diversifies
and, in so doing, may be
able to lower its overall risk.
Firm-Portfolio Approach
The lower the degree of
positive correlation between
possible net present values
for projects, the lower the
standard deviation of
possible net present values,
all other things being equal.
Firm-Portfolio Approach
Whether the coefficient of
variation declines when an
investment project is added
also depends on the
expected value of net
present value for the
project.
Managerial (Real) Options
It is management
flexibility to make future
decisions that affect a
projects expected cash
flows, life, or future
acceptance.
Managerial (Real) Options
The presence of
managerial, or real,
options enhances the
worth of an investment
project. The worth of a
project can be viewed as
its net present value,
calculated in the
Managerial (Real) Options
The greater the
uncertainty, the greater
the chance that an option
will be exercised, and
hence, the greater the
options value.
Types of Managerial Options
Option to expand (or
contract)
Option to abandon
Option to postpone
Option to Expand (or
Contract)
An important option which
allows the firm to expand
production if conditions
become favorable and to
contract production if
conditions become
unfavorable.
Option to Abandon
If a project has
abandonment value, this
effectively represents a
put option to the
projects owner.
Option to Abandon
In general, an investment project
should be abandoned when
(1) its abandonment value exceeds
the present value of the projects
subsequent future cash flows, and
(2) it is better to abandon the
project at that time than it is to
abandon it at some future date.
Option to Postpone
For some projects
there is the option to
wait and thereby to
obtain new information.
REFERENCE:

Fundamentals of Financial Management,

13th edition

By : Van Horne and John M. Wachowicz