Fin650:Project Appraisal

Lecture 4-5
Project Appraisal Under Uncertainty and
Appraising Projects with Real Options
1

Project Analysis Under

Certainty: Recap
Discounted cash flow techniques
The ideal investment decision making
technique is Net Present Value.
N P V measures the equivalent present
wealth contributed by the investment.
NPV-- relates directly to the firms goal of
wealth maximization
-- employs the time value of money
-- can be used in all types of investments
-- can be adjusted to incorporate risk.

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Other Project Evaluation

Techniques
Internal Rate of Return calculates
The discount rate that gives the
project an NPV of 0. If the IRR is
greater than the required rate, the
project is accepted. IRR
is given as % pa.

n
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Other Project Evaluation

Techniques

Modified Internal Rate of Return

calculates the discount rate that gives
the project an NPV of $0, when future
cash flows can be re-invested at the
Re-Investment Rate, a rate different
from the IRR. If the MIRR is greater
that the required rate, the project is
accepted. MIRR is given as % pa.

Other Project Evaluation

Techniques
Non-Discounted Cash Flow Techniques

Accounting Rate of Return- measures the ratio

of annual average accounting income to an
asset base value. ARR is given as % pa.
Payback Period measures the length of time
required to retrieve the initial cash outlay.
Payback is given as number of years.

Selection of Techniques
NPV is the technique of choice; it satisfies the
requirements of: the firms goal, the time value of
money, and the absolute measure of investment.
IRR is useful in a single asset case, where the
Cash flow pattern is an outflow followed by all
positive inflows. In other situations the IRR may
not rank mutually exclusive assets properly, or
may have zero or many solutions.
6

Selection of Techniques
MIRR

is useful in the same situations as

the IRR, but requires the extra prediction
of a re-investment rate.
ARR allows many valuations of the asset
base, does not account for the time value
of money, and does not relate to the firms
goal. It is not a recommended method.
PB does not allow for the time value of
money, and does not relate to the firms
goal. It is not a recommended method
except for situations of uncertainty.
7

The Notion of Certainty

Certainty assumption

Financial decision makers are rational, risk-averse,

wealth maximizers
Financial markets are efficient and competitive
Future is certain, outcome is known

Certainty allows demonstration and evaluation

of the capital budgeting techniques, whilst
avoiding the complexities involved with risk.
Certainty requires forecasting, but forecasts
which are certain.
Certainty is useful for calculation practice.
Risk is added as an adaption of an evaluation
model developed under certainty.
8

NPV Applications
Asset retirement
Asset replacement
Correct ranking of mutually exclusive
projects.
Where projects have different lives.
Where projects have different outlays.
9

Class Exercise: Asset

Replacement
Assume that SNU Ltd. has an asset with about three years of
Operating life remaining, today being the assets fifth year.
The net operating inflows are shown in the table below. When
should the asset be retired?
End of year

Net operating
inflow

Salvage value

22,000

7,000

17,500

6,400

14,375

4,250

8980
10

Net

Present
Value

THE model to use in all investment

evaluations.
Other criteria, such as IRR, MIRR,
ARR,and Payback may be used as
complementary measures.

Class Exercise
Consider the following three cash flow profiles:
Year ending
0

Project 1

-100

20

20

20

20

120

Project 2

-100

33.44

33.44

33.44

33.44

33.44

Project 3

-100

85.22

85.22

85.22

85.22

-300

Calculate IRR, NPV, and Payback periods for the projects

12

Class Exercise
Project

IRR(%)

NPV

Payback

20

37.9

20

26.8

19.9, 44.4

-16.4

1.2

13

Pitfalls in Project Appraisal

Specifying projects incremental cash flow

requires care

Relevant expected after-tax cash flow associated with

two mutually exclusive scenarios, without and with the
project
Allocation of overheads
Expected versus most likely cash flows

Mean versus mode

Limited capacity

The IRR is biased

The IRRs of projects with different cash flow profiles are

not comparable
Projects with equal IRR can have different NPVs when
they have different payback periods
IRR calculation uses IRR itself as the discount rate
14

Pitfalls in Project Appraisal

The payback period is often ambiguous

Discount rates are frequently wrong

Does not reflect the time value of money

Ignores cash flows after the payback period
Unsuitable for projects requiring investment over a period of
years
Fallacy of single discount rate, projects have widely differing
risks

Rising inflation rates are dangerous

Use of a nominal rate to discount nominal cash flows and use

of a real rate to discount real cash flows
All cash flows do not change equally with the rate of inflation
Inflation increases the required investment in nominal working
capital
Inflation increases corporate tax rate
15

Pitfalls in Project Appraisal

The precise timing of cash flows is important

Cash flows occur at the end of the year assumption

Two methods for precise discounting

Forecasting is often untruthful

Use monthly discount rates

For example 1.5 year discount factor

Increase the hurdle rate by the average forecasting bias

Subsidiary forecast

Risk adds value to real options

Real options affect the NPV rule

16

Critique of DCF

Ignores risks inherent in capital projects

Uses the same discount rate to cash flows with

different risks
Uses the same discounts rates throughout the
life of the project

Considers investment one-time irreversible

decision

17

Project Analysis Under

Risk
Incorporating risk into project
analysis through adjustments to the
discount rate, and by the certainty
equivalent factor.

18

Introduction: What is
Risk?

Risk is the variation of future

expectations around an expected
value.
Risk is measured as the range of
variation around an expected value.
Risk and uncertainty are
interchangeable words.

19

Where Does Risk Occur?

In project analysis, risk is the

variation in predicted future cash
flows.

Forecast Estimates of
Varying Cash Flows
End of
Year 0

End of
Year 1

-$1,257

-$760
-$235
$127
$489
$945

End of
Year 2

?
?
?
?
?

-$876
-$231
$186
$875
$984

End of
Year 3

?
?
?
?
?

-$546
-$231
$190
$327
$454

?
?
?
?
?

20

Handling Risk
There are several approaches to handling risk:
Risk may be accounted for by (1) applying a
discount rate commensurate with the riskiness of
the cash flows, and (2), by using a certainty
equivalent factor
Risk may be accounted for by evaluating the project
using sensitivity and breakeven analysis.
Risk may be accounted for by evaluating the
project under simulated cash flow and discount
rate scenarios.

21

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Using a Risk Adjusted
Discount Rate

The structure of the cash flow

discounting mechanism for risk is:-

The $ amount used for a risky cash flow is the

expected dollar value for that time period.

A risk adjusted rate is a discount rate calculated to

include a risk premium. This rate is known as the
RADR, the Risk Adjusted Discount Rate.

22

Defining a Risk Adjusted

Discount Rate

1.
2.
3.

Conceptually, a risk adjusted discount

rate, k, has three components:A risk-free rate (r), to account for the
time value of money
An average risk premium (u), to
account for the firms business risk
An additional risk factor (a) , with a
positive, zero, or negative value, to
account for the risk differential
between the projects risk and the
firms business risk.
23

Calculating a
Risk Adjusted Discount
A risky discount rate is conceptually defined
Rate
as:
k=r+u+a
Unfortunately, k, is not easy to estimate.
Two approaches to this problem are:
1. Use the firms overall Weighted Average Cost of
Capital, after tax, as k . The WACC is the overall rate
of return required to satisfy all suppliers of capital.
2. A rate estimating (r + u) is obtained from the

Capital Asset Pricing Model, and then a is added.

24

Calculating the WACC

Assume a firm has a capital structure of:
50% common stock, 10% preferred stock,
40% long term debt.

Rates of return required by the holders of each are :

common, 10%; preferred, 8%; pre-tax debt, 7%.
The firms income tax rate is 30%.
WACC = (0.5 x 0.10) + (0.10 x 0.08) +
(0.40 x (0.07x (1-0.30)))
= 7.76% pa, after tax.
25

The Capital Asset Pricing

Model
This model establishes the covariance
between market returns and returns
on a single security.
The covariance measure can be used
to establish the risky rate of return, r,
for a particular security, given
expected market returns and the
expected risk free rate.

26

Calculating r from the

CAPM

The equation to calculate r, for a

security with a calculated Beta is:

r is the required rate of

Where : E ~
return being calculated, R f is the risk free
rate: is the Beta of the security, and Rm
is the expected return on the market.
27

Beta is the Slope of an

Ordinary Least Squares
Regression Line
Share Returns Regressed On Market
Returns

Returns of Share, %
pa

0.12

-0.10

0.10
0.08
0.06
0.04
0.02
-0.05

0.00
-0.020.00

0.05

0.10

0.15

0.20

-0.04

Returns on Market, % pa

28

The Regression Process

The value of Beta can be estimated as the regression coefficient
of a simple regression model. The regression coefficient a
represents the intercept on the y-axis, and b represents Beta,
the slope of the regression line.

rit a bi rmt u it

Where,

= rate of return on individual firm is shares at time t

rmt = rate of return on market portfolio at time t
uit = random error term (as defined in regression
analysis)
29

The Certainty Equivalent

Method: Adjusting the cash
flows to their certain
Theequivalents
Certainty Equivalent method adjusts the
cash flows for risk, and then discounts these
certain cash flows at the risk free rate.

CF1 b CF2 b
NPV

etc CO
1
2
1 r
1 r
Where: b is the certainty coefficient (established by
management, and is between 0 and 1); and ris the
risk free rate.
30

Analysis Under Risk

:Summary

Risk is the variation in future cash flows

around a central expected value.
Risk can be accounted for by adjusting the
NPV calculation discount rate: there are two
methods either the WACC, or the CAPM
Risk can also be accommodated via the
Certainty Equivalent Method.
All methods require management judgment
and experience.
31

Appraising Projects with Real

Options
Critics of the DCF criteria argue that
cash flow analysis fails to account for
flexibility in business decisions.
Real option models are more focused on
describing uncertainty and in particular
the managerial flexibility inherent in
many investments
Real options give the firm the
opportunity but not the obligation to take
certain action
32

What is Real Options?

Application of financial options theory to
investment in a non-financial (real) asset
Hence the name real options

33

Real Options: Link between

Investments and Black-Scholes
Inputs

34

Real Options in Capital

Projects

Ten real options to:

Invest in a future capital project

Delay investing in a project
Choose the projects initial capacity
Expand capacity of the project subsequent to the
original investment
Change the projects technology
Change the use of project during its life
Shutdown the project with the intention of restarting it
later
Abandon or sell the project
Extend the life of the project
Invest in further projects contingent on investment in
the initial project
35

Real Options in Capital

Projects

Simply adjusting the discount rate for the risk

does not account for the full impact of uncertainty
Uncertainty affects investment in two ways

Uncertainty about investment (I) required

Uncertainty about the present value (PV) that the future
investment might generate

Since the future values (FVs) of I and PV may

both be uncertain, we need to simplify by
combing them into a single variable:
Profitability index = Present value/Investment
PI = PV/I
36

Real Options in Capital

Projects

Real option and profitability index

Exercise real option only if PI turns out to be

greater than of equal to zero
Otherwise, keep the funds I invested in the
financial market where PI virtually always
equals 1.00

37

Uncertainty and Real

Options Value

In the year 2000 GROWTHCO had a prospective project

under development
The decision to invest will not be made until 2003
Investment in the project is contingent upon PI being
greater than 1
Therefore, in 2000 the potential to invest in 2003 was a
real option for GROWTHCO
Management expected to invest $25 million in the project if
PI>1

R&D budget to make the project ready is $ 1 million per

year.
The actual size of the investment is uncertain, it depended
on market information fully available until 2003
Real options payoff histogram
38

Real Options in Capital

Projects
Probability

Real Option Payoff Histogram

0.4

0.8

1.0

1.4

1.8

PI

2.0

39

Calculation of the Expected PI

of Payof

The first column shows selected intervals of the PI used in

the histogram
The second column is the average value of the PI for each
interval
The third column gives the probability management
assigned to each interval
The fourth column gives the value of the PI of the payoff
depending on whether or not management would exercise
the investment option
The final column gives the product of the PI and its
probability for each interval
The sum at the bottom of the column gives the expected
PI of the payoff

40

Calculation of the Expected PI

of Payof

For example, in the fourth row PI falls between 1.2 and 1.6
The second column shows the average value of the interval, 1.4
The third column shows the probability management assigned to
this interval, 0.21
Because the average interval value of 1.4 is greater than 1,
management would intend to invest in this interval, gaining an
average PI value of 1.4 with probability of 0.21
The final column gives the product of the PI value (1.4) and its
probability(0.21)i.e. 0.294
The first two rows PI value is less than 1, management under
these circumstances would invest in financial market and get a
value of 1.00, as shown in the fourth column
The third row has an interval value of 1. Therefore we use
weighted average 0.5x1.1+0.5x1=1.05
The expected value of the investments PI with option payoff is
1.225 as shown at the bottom row

41

Calculation of expected PI
of payof

Interval

Interval value

Probability

PI of payoff

Expected PI of payoff

0<x<=0.4

0.2

0.16

1.00

0.160

0.4<x<=0.8

0.6

0.21

1.00

0.210

0.8<x<=1.2

0.26

1.05

0.273

1.2<x<=1.6

1.4

0.21

1.40

0.294

1.6<x<=2

1.8

0.16

1.80

0.288

1.00

1.225

42

Risk Neutral Valuation of Real

Options
Managements option to reject the unfavorable payoffs
alters distributions of PI
Risk adjustment factor
F = Risk adjustment factor for PV/ Risk adjustment factor for
I
Risk adjustment factor for PV= (1+RF)T/ (1+RPV)T
Risk adjustment factor for I= (1+RF)T/ (1+RI)T
Therefore, F = (1+RI)T/ (1+RPV)T , where
RI represents the discount rate for future investment
expenditure and RPV is the Projects discount rate
Assuming RI= 0.5 and RPV=0.10, we get F=0.870

Multiply all the class intervals by the risk-adjustment

factor
43

Real Options in Capital

Projects
Probability

Risk adjusted Histogram

0.4

0.8

1.12
1.0

1.49

PI

1.87

44

Risk-neutral Valuation of the

expected PI with payof
Interval
value

Probability

PI of payoff

Expected PI of payoff

Interval

Risk-neutral
interval

0<x<=0.4

0<x<=0.37

0.18

0.16

1.00

0.160

0.4<x<=0.8

0.37<x<=0.74

0.55

0.21

1.00

0.210

0.8<x<=1.2

0.74<x<=1.10

0.92

0.26

1.01

0.264

1.2<x<=1.6

1.10<x<=1.47

1.29

0.21

1.29

0.271

1.6<x<=2

1.47<x<=1.84

1.66

0.16

1.66

0.265

1.00

1.169

45

Risk Neutral Valuation of Real

Options
Re-calculate other values using the risk-neutral intervals.
The result is a smaller expected PI payoff 1.169
Present value of the option= Present value of the
expected investment expenditure * (Present value of the
PI-1)
= $25/(1+0.07)3*(1.169-1)= $3.449 million
R&D budget to make the project ready is $ 1 million per
year. The present value of this three year annuity
discounted at 5% is $2.723 million
Therefore, addition to shareholder value, due to
exercising this option, is $3.449 - $2.723 million =
0.726 million
R&D should go ahead

46