Risk Topics and Real Options in Capital Budgeting

1. Risk Topics and Real Options in Capital Budgeting Chapter 11 © 2003 South-Western/Thomson Learning

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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