Total
Project Risk
Contribution
Managerial
14-2
(Real) Options
Probability
.05
.25
.40
.25
.05
Cash Flow
$ -3,000
1,000
5,000
9,000
13,000
Probability Distribution
of Year 1 Cash Flows
Proposal A
Probability
.40
.25
.05
-3,000
1,000
5,000
9,000
13,000
P1
(CF1)(P1)
.05
$ -150
.25
250
.40
2,000
.25
2,250
.05
650
CF1=$5,000
Variance of Year 1
Cash Flows (Proposal A)
14-6
(CF1)(P1)
(CF1 - CF1)2(P1)
$ -150
250
2,000
2,250
650
$5,000
Variance of Year 1
Cash Flows (Proposal A)
14-7
(CF1)(P1)
(CF1 - CF1)2*(P1)
$ -150
250
2,000
2,250
650
$5,000
3,200,000
4,000,000
0
4,000,000
3,200,000
14,400,000
Summary of Proposal A
The standard deviation = SQRT (14,400,000)
= $3,795
The expected cash flow
= $5,000
Coefficient of Variation (CV) = $3,795 / $5,000
= 0.759
CV is a measure of relative risk and is the ratio of
standard deviation to the mean of the distribution.
14-8
Probability
.05
.25
.40
.25
.05
Cash Flow
$ -1,000
2,000
5,000
8,000
11,000
Probability Distribution
of Year 1 Cash Flows
Proposal B
Probability
.40
.25
.05
-3,000
1,000
5,000
9,000
13,000
P1
(CF1)(P1)
.05
$ -50
.25
500
.40
2,000
.25
2,000
.05
550
CF1=$5,000
Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$
-50
500
2,000
2,000
550
$5,000
14-12
(CF1 - CF1)2(P1)
( -1,000 - 5,000)2 (.05)
( 2,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 8,000 - 5,000)2 (.25)
(11,000 - 5,000)2 (.05)
Variance of Year 1
Cash Flows (Proposal B)
(CF1)(P1)
$
-50
500
2,000
2,000
550
$5,000
14-13
(CF1 - CF1)2(P1)
1,800,000
2,250,000
0
2,250,000
1,800,000
8,100,000
Summary of Proposal B
The standard deviation = SQRT (8,100,000) =
$2,846
The expected cash flow = $5,000
Coefficient of Variation (CV) = $2,846 / $5,000
= 0.569
The standard deviation of B < A ($2,846< $3,795), so B
is less risky than A.
The coefficient of variation of B < A (0.569<0.759), so B
has less relative risk than A.
14-14
1
14-15
3
Year
-$900
14-17
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.
1
-$900
14-18
(.20) $1,200 1
(.60)
$450
(.20)
-$600 3
Year 1
-$900
(.60)
60
(.20)
.20
14-19
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2
Each node in
Year 2
represents a
branch of our
probability
tree.
The
probabilities
are said to be
conditional
probabilities.
probabilities
-$900
(.60)
60
(.20)
.20
14-20
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2
.02 Branch 1
.12 Branch 2
.06 Branch 3
.21 Branch 4
.24 Branch 5
.15 Branch 6
.02 Branch 7
.10 Branch 8
.08 Branch 9
The probability
tree accounts for
the distribution
of cash flows.
Therefore,
discount all cash
flows at only the
risk-free rate of
return.
14-21
NPV = i= 1 (NPVi)(Pi)
The NPV for branch i of
the probability tree for two
years of cash flows is
CF1
CF2
NPVi =
+
1
(1 + Rf ) (1 + Rf )2
- ICO
-$900
(.60)
60
(.20)
.20
14-22
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2
$ 2,238.32
$ 1,331.29
$ 1,059.18
$
344.90
72.79
-$
199.32
-$ 1,017.91
-$ 1,562.13
-$ 2,106.35
NPVi
$ 2,238.32
$ 1,331.29
$ 1,059.18
$ 344.90
$
72.79
-$ 199.32
-$ 1,017.91
-$ 1,562.13
-$ 2,106.35
P(1,2)
NPVi * P(1,2)
.02 $ 44.77
.12 $159.75
.06 $ 63.55
.21 $ 72.43
.24 $ 17.47
.15 -$ 29.90
.02 -$ 20.36
.10 -$156.21
.08 -$168.51
P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08
Variance = $1,031,800.31
14-24
Summary of the
Decision Tree Analysis
The standard deviation =
SQRT ($1,031,800) = $1,015.78
The expected NPV
14-25
= -$
17.01
Simulation Approach
An approach that allows us to test
the possible results of an
investment proposal before it is
accepted. Testing is based on a
model coupled with probabilistic
information.
14-26
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
Operating costs and fixed costs
14-27
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.
14-28
Simulation Approach
PROBABILITY
OF OCCURRENCE
14-29
Combination of
Proposals A and B
CASH FLOW
Proposal A
TIME
TIME
TIME
14-30
NPVP = ( NPVj )
j=1
Determining Portfolio
Standard Deviation
P =
jk
j=1 k=1
jk = j k r jk .
E: Existing Projects
8 Combinations
E
E+1
E+2
E+3
E+1+2
E+1+3
E+2+3
E+1+2+3
A, B, and C are
dominating combinations
from the eight possible.
14-33
Combinations of
Risky Investments
C
B
E
A
Standard Deviation
Abandon
Postpone
14-35
-$900
(.60)
60
(.20)
.20
14-36
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.25) $ 300
Assume that
this project
can be
abandoned at
the end of the
first year for
$200.
$200
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
What is the
project
worth?
worth
(.35) $ 900
(.40) $ 600
Year 2
Project Abandonment
(.20)
.20 $1,200 1
-$900
(.60)
60
(.20)
.20
14-37
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
Year 2
Node 3:
3
(500/1.05)(.1)+
500
(-100/1.05)(.5)+
-100
(-700/1.05)(.4)=
-700
($476.19)(.1)+
-($ 95.24)(.5)+
-($666.67)(.4)=
-($266.67)
Project Abandonment
(.20)
.20 $1,200 1
-$900
(.60)
60
(.20)
.20
14-38
$450
-$600 3
Year 1
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
The optimal
decision at the
end of Year 1 is
to abandon the
project for
$200.
$200
(.25) $ 300
$200 >
(.10) $ 500
(.50) -$ 100
(.40) -$ 700
-($266.67)
Year 2
What is the
new project
value?
Project Abandonment
(.20)
.20 $1,200 1
-$900
(.60)
60
(.20)
.20
$450
-$400* 3
(.10) $2,200
(.60) $1,200
(.30) $ 900
(.35) $ 900
(.40) $ 600
(.25) $ 300
(1.0) $
Year 1
Year 2
$ 2,238.32
$ 1,331.29
$ 1,059.18
$
344.90
72.79
-$
199.32
-$ 1,280.95