The document discusses various approaches to assessing risk in capital budgeting projects, including probability trees, simulation, and portfolio approaches. It also discusses how managerial flexibility, or real options, can enhance project value. Real options include the option to expand or contract a project, the option to abandon a project, and the option to postpone a project to obtain more information. Diversification across projects with low correlations can help reduce overall risk at the firm level. Riskier projects require higher returns, so risk assessment is an important part of capital budgeting.
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Notes Accounting 18
Original Title
Chapter 14Risk& Managerial Options in Capital Budgeting
The document discusses various approaches to assessing risk in capital budgeting projects, including probability trees, simulation, and portfolio approaches. It also discusses how managerial flexibility, or real options, can enhance project value. Real options include the option to expand or contract a project, the option to abandon a project, and the option to postpone a project to obtain more information. Diversification across projects with low correlations can help reduce overall risk at the firm level. Riskier projects require higher returns, so risk assessment is an important part of capital budgeting.
The document discusses various approaches to assessing risk in capital budgeting projects, including probability trees, simulation, and portfolio approaches. It also discusses how managerial flexibility, or real options, can enhance project value. Real options include the option to expand or contract a project, the option to abandon a project, and the option to postpone a project to obtain more information. Diversification across projects with low correlations can help reduce overall risk at the firm level. Riskier projects require higher returns, so risk assessment is an important part of capital budgeting.
(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: