Risk and Managerial Options
in Capital Budgeting
Risk is defined as the variability of returns
from those that are expected, greater the
variability the riskier the project is said to be.
OR
Riskiness of an investment project is the
variability of its cash flows from those that
are expected
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
State Probability Cash Flow
Deep Recession .05 $ -3,000
Mild Recession .25 1,000
Normal .40 5,000
Minor Boom .25 9,000
Major Boom .05 13,000
Proposal A
.40
Probability
.25
.05
-3,000 1,000 5,000 9,000 13,000
Cash Flow ($)
CF1 P1 (CF1)(P1)
$ -3,000 .05 $ -150
1,000 .25 250
5,000 .40 2,000
9,000 .25 2,250
13,000 .05 650
S=1.00 CF1=$5,000
(CF1)(P1) (CF1 - CF1)2*(P1)
$ -150 3,200,000
250 4,000,000
2,000 0
2,250 4,000,000
650 3,200,000
$5,000 14,400,000
The standard deviation = SQRT (14,400,000)
= $3,795
The expected cash flow = $5,000
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State Probability Cash Flow
Deep Recession .05 $ -1,000
Mild Recession .25 2,000
Normal .40 5,000
Minor Boom .25 8,000
Major Boom .05 11,000
Proposal B
.40
Probability
.25
.05
-3,000 1,000 5,000 9,000 13,000
Cash Flow ($)
CF1 P1 (CF1)(P1)
$ -1,000 .05 $ -50
2,000 .25 500
5,000 .40 2,000
8,000 .25 2,000
11,000 .05 550
S=1.00 CF1=$5,000
(CF1)(P1) (CF1 - CF1)2(P1)
$ -50 ( -1,000 - 5,000)2 (.05)
500 ( 2,000 - 5,000)2 (.25)
2,000 ( 5,000 - 5,000)2 (.40)
2,000 ( 8,000 - 5,000)2 (.25)
550 (11,000 - 5,000)2 (.05)
$5,000
(CF1)(P1) (CF1 - CF1)2(P1)
$ -50 1,800,000
500 2,250,000
2,000 0
2,000 2,250,000
550 1,800,000
$5,000 8,100,000
The standard deviation = SQRT (8,100,000)
= $2,846
The expected cash flow = $5,000
PROPOSALS EXPECTED STANDARD COEFFICIEN OF ACCEPT/
VALUES DEVIATION VARIATION REJECT
C.V= S.D/E(R)
PROPOSAL $ 5,000 $3,795 =3795/5000 Reject
A =0.759
PROPOSAL $ 5,000 $2,846 = 2846/5000 Accept
B = 0.5692
Projects have risk that may change from period
to period.
A graphic or tabular approach for organizing the
possible cash-flow streams generated by an
investment.
The presentation resembles the branches of a
tree.
Specify the likely future cash flows of a project as
they relate to the outcomes in the previous
periods.
Each complete branch represents one possible
cash-flow sequence.
Basket Wonders is examining a
project that will have an initial cost
today of $900. Uncertainty
surrounding the first year cash
flows creates three possible cash-
flow scenarios in Year 1.
Probability Tree Approach
(.20) $1,200 Node 1: 20% chance of a
1 $1,200 cash-flow.
Node 2: 60% chance of a
(.60) $450 $450 cash-flow.
-$900 2
Node 3: 20% chance of a
-$600 cash-flow.
(.20) -$600
3
Year 1
Probability Tree Approach
(.10) $2,200
Each node in
(.20) $1,200 (.60) $1,200 Year 2
1 represents a
(.30) $ 900
branch of our
(.35) $ 900 probability tree.
(.60) $450 (.40) $ 600 The probabilities
-$900 2 are said to be
(.25) $ 300
conditional
(.10) $ 500 probabilities.
(.20) -$600 (.50) -$ 100
3
(.40) -$ 700
Year 1 Year 2
(.10) $2,200
.02 Branch 1
(.20) $1,200 (.60) $1,200 .12 Branch 2
1
(.30) $ 900 .06 Branch 3
(.35) $ 900 .21 Branch 4
(.60) $450 (.40) $ 600 .24 Branch 5
-$900 2 .15 Branch 6
(.25) $ 300
.02 Branch 7
(.10) $ 500 .10 Branch 8
(.20) -$600 (.50) -$ 100 .08 Branch 9
3
(.40) -$ 700
Year 1 Year 2
The probability tree accounts for the
distribution of cash flows. Therefore,
discount all cash flows at only the risk-free
rate of return which is 5% in this case.
NPV = S (NPVi)(Pi)
Branch NPVi P(1,2) NPVi * P(1,2)
Branch 1 $ 2,238.32 .02 $ 44.77
Branch 2 $ 1,331.29 .12 $159.75
Branch 3 $ 1,059.18 .06 $ 63.55
Branch 4 $ 344.90 .21 $ 72.43
Branch 5 $ 72.79 .24 $ 17.47
Branch 6 -$ 199.32 .15 -$ 29.90
Branch 7 -$1,017.91 .02 -$ 20.36
Branch 8 -$1,562.13 .10 -$156.21
Branch 9 -$2,106.35 .08 -$168.51
Expected Net Present Value = -$ 17.01
NPVi P(1,2) (NPVi - NPV )2[P(1,2)]
$ 2,238.32 .02 $ 101,730.27
$ 1,331.29 .12 $ 218,149.55
$ 1,059.18 .06 $ 69,491.09
$ 344.90
.21 $ 27,505.56
$ 72.79
.24 $ 1,935.37
-$ 199.32
-$ 1,017.91 .15 $ 4,985.54
-$ 1,562.13 .02 $ 20,036.02
-$ 2,106.35 .10 $ 238,739.58
.08 $ 349,227.33
Variance = $1,031,800.31
The standard deviation = SQRT ($1,031,800)
= $1,015.78
The expected NPV = -$ 17.01
Management flexibility to make
future decisions that affect a
project’s expected cash flows, life,
or future acceptance.
Project Worth = NPV + Option(s) Value
Expand (or contract)
◦ Allows the firm to expand (contract) production if
conditions become favorable (unfavorable).
Abandon
◦ Allows the project to be terminated early.
Postpone
◦ Allows the firm to delay undertaking a project
(reduces uncertainty via new information).
