CHAPTER 12

RISK TOPICS AND REAL OPTIONS IN CAPITAL BUDGETING

FOCUS Traditional capital budgeting techniques compute point estimates of NPV and IRR with no measure of variability. Hence they dont give managers the information necessary to include a tradeoff between risk and expected return in their decisions. This chapter is concerned with modern approaches to incorporating risk into capital budgeting. The techniques considered include probabilistic cash flows, risk adjusted discount rates and the idea of real options. PEDAGOGY We begin with the idea that cash flows are random variables, which implies that project NPVs and IRRs are also random variables with associated probability distributions. We then explore the implications of choosing a high risk project over one with less variability, and conclude that managements would often trade higher return for lower risk if they had the necessary information. With that background we explore the currently available methods for incorporating risk into capital budgeting calculations including a detailed explanation of real options thinking. TEACHING OBJECTIVES Students should gain an appreciation of risk in the capital budgeting context, and be relatively well-versed in the approaches scholars have taken to incorporating it into the decision making process. At the same time they should understand that putting risk into capital budgeting is difficult, and that the methods currently available are often less than completely satisfactory. OUTLINE I. RISK IN CAPITAL BUDGETING GENERAL CONSIDERATIONS A. Cash Flows as Random Variables Incorporating risk by viewing individual cash flows as random variables with probability distributions. NPV and IRR are then also random variables. B. The Importance of Risk in Capital Budgeting Why risk matters, making mistakes on individual projects and changing the risk character of the company. C. Incorporating Risk Into Capital Budgeting Numerical and Computer Methods Scenario/Sensitivity Analysis and Simulation Decision Tree Analysis D. Real Options The concept of an option. Real options thinking applied to capital budgeting. Valuing real options the NPV and risk effects. Designing real options into projects, types of real options. E. Incorporating Risk Into Capital Budgeting The Theoretical Approach - Risk Adjusted Rates of Return The concept of adjusting for risk by raising the threshold (hurdle) rate thus making risky projects less acceptable. F. Estimating Risk Adjusted Rates Using CAPM Using the SML to estimate appropriate risk adjusted rates for project analysis. The kind of risk CAPM estimates and whether it is appropriate for capital budgeting decisions. G. Problems with the Theoretical Approach 29

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Finding the right beta, concerns about the appropriate risk definition. QUESTIONS 1. In 1983 the Bell Telephone System, which operated as AT&T, was broken up, resulting in the creation of seven regional telephone companies. AT&T stockholders received shares of the new companies and the continuing AT&T, which handled long distance services. Prior to the breakup, telephone service was a regulated public utility. That meant AT&T had a monopoly on the sale of its service, but couldnt charge excessive prices due to government regulation. Regulated utilities are classic examples of low risk modest return companies. After the breakup, the "Baby Bells," as they were called, were freed from many of the regulatory constraints under which the Bell System operated, and at the same time had a great deal of money. The managements of these young giants were determined to be more than the staid old-line telephone companies they'd been in the past. They were quite vocal in declaring their intentions to undertake ventures in any number of new fields, despite the fact that virtually all of their experience was in the regulated environment of the old telephone system. Many stockholders were alarmed and concerned by these statements. Comment on what their concerns may have been. ANSWER: The stockholders probably invested in phone company stocks at least partially because of the stability and low risk of regulated public utilities. If the Baby Bells expanded into risky unregulated businesses in which they had little experience, the nature of the companies could shift toward higher risk. This would clearly be upsetting to people who had invested for stability in the first place. 2. A random variable is defined as the outcome of one or more chance processes. Imagine that you're forecasting the cash flows associated with a new business venture. List some of the things that come together to produce cash flows in future periods. Describe how they might be considered to be outcomes of chance processes and therefore random variables. Cash flow forecasts for a project are put together by using Equations (10-1) and (10-2) to calculate the project's NPV and IRR. That makes NPV and IRR random variables as well. Is their variability likely to be greater or less than the variability of the individual cash flows making them up? ANSWER: Revenues depend on The effectiveness of advertising and promotion Customer response to product and promotion activity Competitive responses to the venture The effectiveness of distribution channels Product quality Costs depend on The price and availability of labor and material Overhead costs The effectiveness of production operations Each of these items is subject to the influence of a variety of physical, administrative and economic forces that can each be positive or negative. The result of such a confluence of different influences tends to vary randomly around some central value. This kind of pattern represents the essence of a random variable. When a random variable is the result of a combination of other random variables, its variability tends to be less than that of the constituent pieces. This is because there is usually some offsetting of the pluses and minuses among the pieces coming together in a typical observation.

Risk Topics and Real Options in Capital Budgeting

31

3. One of the problems of using simulation to incorporate risk into capital budgeting is related to the idea that the probability distributions of successive cash flows usually are not independent. If the first period's cash flow is at the high end of its range, for example, flows in subsequent periods are more likely to be high than low. Why do you think this is generally the case? Describe an approach through which the computer might adjust for this phenomenon to portray risk better. ANSWER: Suppose a project's cash flows depend, among other things, on customer acceptance of a product. Before any marketing is done, we project acceptance in each period as a random variable that defines the volume of product sold. However, acceptance really isn't independent from one period to the next. For most products it's either good or bad throughout the project's entire life. That means choosing an independent observation in successive periods isn't a very realistic way to model the process. For example, it's unlikely that a very good response in one period will be followed by a very poor response in the next. If acceptance is good in the first period, it's likely to be pretty good in the second as well. But treating acceptance as independent from period to period is likely to result in simulation runs in which it varies back and fourth from great to terrible any number of times. That's not realistic. A conceptual way around the problem is to define an initial random variable for acceptance that sets the level of the mean values of the periodic acceptance random variables throughout the project's life. This r.v. would be drawn only once per simulation run and would define acceptance as good or bad for the whole run. The program would raise the means of all the acceptance r.v.s if a good observation is drawn, and lower them if a poor one comes up. 4. Why is it desirable to construct capital budgeting rules so that higher risk projects become less acceptable than lower risk projects? ANSWER: A high risk project has a significant probability of turning out worse than expected. Requiring a higher expected outcome for acceptance for such a project puts a cushion between the firm and the consequences of a miss in predicting the project's outcome. This makes failure or loss less likely. 5. Rationalize the appropriateness of using the cost of capital to analyze normally risky projects and higher rates for those with more risk. ANSWER: Risky projects are less desirable than low risk projects with the same expected return, because there is more chance that a significantly unfavorable outcome will occur. Hence, it's desirable to discriminate against such projects in the capital budgeting process. Using a risk-adjusted rate instead of the cost of capital when project risk is high is a mechanical method of making risky projects less acceptable. The method simply requires that a risky project have a higher expected return to qualify than a lower risk project. The cost of capital reflects the current state of the business, and therefore can be associated with normally risky projects. Higher rates are logically appropriate for higher risk projects. 6. Evaluate the conceptual merits of applying CAPM theory to the problem of determining risk adjusted interest rates for capital budgeting purposes. Form your own opinion based on your study of CAPM (Chapter 9) and the knowledge you're now developing of capital budgeting. The issue is concisely summarized by Figure 12.7. Is the special concept of risk developed in portfolio theory applicable here? Don't be intimidated into thinking that because the idea is presented in textbooks, it's necessarily correct. Many scholars and practitioners feel this application stretches theory too far. On the other hand, others feel it has a great deal of merit. What do you think and why? ANSWER: This is an opinion question for which there isn't a right or wrong answer.

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BUSINESS ANALYSIS 1. Ed Draycutt is the engineering manager of Airway Technologies, a firm that makes computer systems for air traffic control installations at airports. He has proposed a new device the success of which depends on two separate events. First the Federal Aviation Administration (FAA) must adopt a recent proposal for a new procedural approach to handling in flight calls from planes experiencing emergencies. Everyone thinks the probability of the FAA accepting the new method is at least 98%, but it will take a year to happen. If the new approach is adopted, radio makers will have to respond within another year with one of two possible changes in their technology. These can simply be called A and B. The A response is far more likely, also having a probability of about 98%. Eds device works with the A system and is a stroke of engineering genius. If the A system becomes the industry standard and Airway has Eds product, it will make a fortune before anyone else can market a similar device. On the other hand if the A system isnt adopted, Airway will lose whatever its put into the new devices development. Developing Eds device will cost about $20 million, which is a very substantial investment for a small company like Airway. In fact, a loss of $20 million would put the firm in danger of failing. Ed just presented his idea to the executive committee as a capital budgeting project with a $20 million investment and a huge NPV and IRR reflecting the adoption of the A system. Everyone on the committee is very excited. Youre the CFO and are a lot less excited. You asked Ed how he reflected the admittedly remote possibility that the A system would never be put in place. Ed, obviously proud of his business sophistication, said hed taken care of that with a statistical calculation. He said adoption of the A system required the occurrence of two events each of which has a 98% probability. The probability of both happening is (.98x.98=.96) 96%. He therefore reduced all of his cash inflow estimates by 4%. He maintains this correctly accounts for risk in the project. Does Ed have the right expected NPV? Whats wrong with his analysis? Suggest an approach that will give a more insightful result. Why might the firm consider passing on the proposal in spite of the tremendous NPV and IRR Ed has calculated? ANSWER: Eds calculation has given him the correct expected NPV but its masked the real risk in the proposal. The problem that isnt shown in his presentation is that theres a 4% probability that Airway will lose $20M on the project and probably be put out of business. That the project involves a substantial risk of ruin should be made explicit in any presentation to management. 2. Might Eds case in the preceding problem be helped by a real option? If so What kind? How would it help? ANSWER: Yes, an abandonment option would help if a substantial portion of the development cost could be avoided or recovered if, during the first year, it starts to look like the A system isnt going to be installed. This could reduce the magnitude of the loss but wouldnt affect its probability. 3. Charlie Henderson, a senior manager in the Bartok Company, is known for taking risks. He recently proposed that the company expand its operations into a new and untried field. He put together a set of cash flow projections and calculated an IRR of 25% for the project. The firm's cost of capital is about 10%. Charlie maintains that the favorability of the calculated IRR relative to the cost of capital makes the project an easy choice for acceptance, and urges management to move forward immediately. Several knowledgeable people have looked at the proposal and feel Charlie's projections represent an optimistic scenario that has about one chance in three of happening. They think the project also has

Risk Topics and Real Options in Capital Budgeting

33

about one chance in three of failing miserably. An important consideration is that the project is large enough to bankrupt the company if it fails really badly. Charlie doesn't want to talk about these issues, claiming the others are being "negative" and that he has a history of success with risky ventures like this. When challenged, he falls back on the 25% IRR versus the 10% cost of capital as justification for his idea. The company president has asked you for your comments on the situation. Specifically address the issue of the 25% IRR versus the 10% cost of capital. Should this project be evaluated by using different standards? How does the possibility of bankruptcy as a result of the project affect the analysis? Are capital budgeting rules still appropriate? How should Charlie's successful record be factored into the president's thinking? ANSWER: This project is indeed high risk since it involves as much as a one third chance of ruining the firm. For that reason measuring the IRR against the cost of capital is meaningless. It should be measured against a risk-adjusted rate that is much higher. Intuitively, it's likely that such a rate would be a good deal more than 25%, and would therefore show the project to be unacceptable. Charlie is committing a rather serious management theory error. He's using part of a theory (traditional capital budgeting) to support a position that the full theory (including risk adjustments) would probably reject. That kind of thinking is extremely dangerous. Many people would argue that capital budgeting isn't appropriate in a case like this because of the significant probability of bankruptcy involved. When the risk of ruin is substantial, risk-averse people often walk away from projects regardless of high expected returns. Stated another way, the project is a little like playing Russian Roulette, and not many people will do that. Charlie's track record might induce the president to take his advice, but it would be hard to describe that action as anything but a high stakes gamble. 4. In evaluating the situation presented in the last problem, you've found a pure play company in the proposed industry whose beta is 2.5. The rate of return on short-term treasury bills is currently 8% and a typical stock investment returns 14%. Explain how this information might affect the acceptability of Charlie's proposal. What practical concerns would you overlay on top of the theory you've just described? Do they make the project more or less acceptable? Does the fact that Bartok has never done this kind of business before matter? How would you adjust for that inexperience? Is the risk of bankruptcy still important? What would you advise doing about that? All things considered, would you advise the president to take on the project or not? ANSWER: The information lets us use the CAPM to calculate a more appropriate risk adjusted rate with which to evaluate the project. The calculation uses the SML as follows. k = kRF + (kM kRF)b = 8% + (14% 8%) 2.5 = 23% The 25% IRR compares favorably to this risk adjusted rate, but not by a great deal. The result is especially marginal considering that the cash flows in Charlie's analysis are probably subjective estimates and likely to be upwardly biased by his enthusiasm. The fact that Bartok has never done this kind of business before argues that the new venture will probably be even riskier than the pure play company. That says the 23% risk adjusted rate is probably too low and should be raised. It's also important to note that the CAPM approach adjusts only for market risk. In this situation, total risk is probably more appropriate. Intuitively, it seems that considering total risk would raise the rate considerably and be likely to make the project unacceptable. The high risk of ruin is still important. Many, if not most, people would find it a show stopper, and advise against the project regardless of the IRR.

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PROBLEMS

Scenario/Sensitivity Analysis: Example 12-1 (page 528)

1. The Glendale Corp. is considering a real estate development project that will cost $5M to undertake and is expected to produce annual inflows between $1M and $4M for two years. Management feels that if the project turns out really well the inflows will be $3M in the first year and $4M in the second. If things go very poorly, on the other hand, inflows of $1M followed by $2.5M are more likely. Develop a range of NPVs for the project if Glendales cost of capital is 12%. SOLUTION: The NPV for either scenario is NPV = C0 + C1[PVF12,1] + C2[PVF12,2] = -$5M + C1(.8929) + C2(.7972) Then for the good scenario we have NPV = $5,000,000 + $3M(.8929) + $4M(.7972) = $5,000,000 + $2,678,700 + $3,188,800 = $867,500 While for the unfavorable scenario we have NPV = $5,000,000 + $1,000,000(.8929) + $2,500,000(.7972) = $5,000,000 + $892,900 + $1,993,000 = $2,114,100 Hence the likely NPV range for the project is between $0.9M and $2.1M. 2. If Glendales management in the last problem attaches a probability of .7 to the better outcome, what is the projects most likely (expected) NPV? SOLUTION: Scenario Good Bad 3. Outcome $ 867,500 ($ 2,114,100) Probability .7 .3 Expected NPV = Outcome x Prob. $ 607,250 ($ 643,230) ($ 26,980)

Keener Clothiers Inc. is considering investing $2 million in an automatic sewing machine to produce a newly designed line of dresses. The dresses will be priced at $200, and management expects to sell 12,000 per year for six years. There is, however, some uncertainty about production costs associated with the new machine. The production department has estimated operating costs at 70% of revenues, but senior management realizes that this figure could turn out to be as low as 65% or as high as 75%. The new machine will be depreciated at a rate of $200,000 per year for six years (straight line, zero salvage). Keeners cost of capital is 14% and its marginal tax rate is 35%. Calculate a point estimate along with best and worst case scenarios for the projects NPV.

Risk Topics and Real Options in Capital Budgeting

35

SOLUTION: ($000) Cash Flow in Years 1-5 Revenues Operating Costs Depreciation EBT Impact Tax EAT Impact Add back depreciation. Cash Flow @65% $2,400 1,560 200 640 224 416 200 616 Cost as a % of Revenue @70% $2,400 1,680 200 520 182 338 200 538 Point Est (2,000) 538 6 14 92.103 @75% $2,400 1,800 200 400 140 260 200 460 Worst (2,000) 460 6 14 (211.213)

Calculating NPVs using a financial calculator yields: Best CFo (2,000) C01 616 F01 6 I 14 NPV 395.419 4.

Assume Keener Clothiers of the last problem assigns the following probabilities to production cost as a percent of revenue % of Revenue Probability 65% .30 70% .50 75% .20 Sketch a probability distribution (histogram) for the projects NPV, and compute its expected NPV. Prob .5

SOLUTION:

.3 .2 NPV ($211) 0 $92 $395 The most likely, or expected, NPV is calculated as follows: Expected NPV = $395,419(.30) + $92,103(.5) - $211,213(.2) = $ = $118,625.70 + $46,051.50 - $42,242.60 = $122,434.60

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Notice that because the probabilities of the 65% and 75% scenarios are not equal, the expected NPV is not that of the 70% scenario. 5. The Blazingame Corporation is considering a three-year project that has an initial cash outflow (C0) of $175,000 and three cash inflows that are defined by the independent probability distributions shown below. All dollar figures are in thousands. Blazingame's cost of capital is 10%. C1 $50 $60 $70 C2 $40 $80 $120 C3 $75 $80 $85 Probability .25 .50 .25

a. Estimate the project's most likely NPV by using a point estimate of each cash flow. What is its probability? b. What are the best and worst possible NPVs? What are their probabilities? c. Choose a few outcomes at random, calculate their NPVs and the associated probabilities, and sketch the probability distribution of the project's NPV. [Hint: The project has 27 possible cash flow patterns (333) each of which is obtained by selecting one cash flow from each column and combining with the initial outflow. The probability of any pattern is the product of the probabilities of its three uncertain cash flows. For example, a particular pattern might be as follows. CI Probability C0 C1 ($175) $50 1.0 .25 C2 $120 .25 C3 $80 .50

The probability of this pattern would be .25 .25 .50 = .03125.] SOLUTION: Although the problem asks for only a few outcomes, we'll list them all and identify the best, worst, and most likely. First restate the matrix of outcomes by multiplying each C i by PVF10,i and rounding to the nearest $1,000: C1 $45 $55 $64 C2 $33 $66 $99 C3 $56 $60 $64 Probability .25 .50 .25

Next enumerate the possible cash flows and calculate their probabilities. ($000) C0 175 C1 45 Worst C2 33 C3 56 60 64 56 60 64 NPV 41 37 33 8 4 0 Probability .25.25.25 = .015625 .25.25.50 = .031250 .25.25.25 = .015625 .25.50.25 = .031250 .25.50.50 = .062500 .25.50.25 = .031250

175

45

66

Risk Topics and Real Options in Capital Budgeting

37

175

45

99

56 60 64 56 60 64 56 60 64 56 60 64 56 60 64 56 60 64 56 60 64

25 29 33 31 27 23 2 6 10 35 39 43 22 18 14 11 15 19 44 48 52

.25.25.25 = .015625 .25.25.50 = .031250 .25.25.25 = .015625 .50.25.25 = .031250 .50.25.50 = .062500 .50.25.25 = .031250 .50.50.25 = .062500 .50.50.50 = .125000 .50.50.25 = .062500 .50.25.25 = .031250 .50.25.50 = .062500 .50.25.25 = .031250 .25.25.25 = .015625 .25.25.50 = .031250 .25.25.25 = .015625 .25.50.25 = .031250 .25.50.50 = .062500 .25.50.25 = .031250 .25.25.25 = .015625 .25.25.50 = .031250 .25.25.25 = .015625 1.000000

175

55

33

175 55 Most likely

66

175

55

99

175

64

33

175

64

66

175

64 Best

99

Finally, sorting the outcomes and grouping within NPV ranges yields the following probability distribution. NPV Range ($000) NPV < $40 $40 < NPV < $30 $30 < NPV < $20 $20 < NPV < $10 $10 < NPV < $00 $00 < NPV < $10 $10 < NPV < $20 $20 < NPV < $30 $30 < NPV < $40 $40 < NPV < $50 NPV > $50 Probability .015625 .078125 .109375 .046875 .125000 .250000 .125000 .046875 .109375 .078125 .015625 1.000000

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Prob(NPV) .25 .20 .15 .10 .05 <40 35 25 15 5 5 15 25 Mid Points of NPV Ranges ($000) 35 45 >50
NPV

6. Sanville Quarries is considering acquiring a new drilling machine which is expected to be more efficient than their current machine. The project is to be evaluated over four years. The initial outlay required to get the new machine operating is $675,000. Incremental cash flows associated with the machine are uncertain, so management developed the following probabilistic forecast of cash flows by year ($000). Sanvilles cost of capital is 10%. Year1 Prob $150 .30 $175 .40 $300 .30 a. b. Year2 $200 $210 $250 Prob .35 .45 .20 Year3 $350 $370 $400 Prob .30 .25 .45 Year4 $300 $360 $375 Prob .25 .35 .40

Calculate the projects best and worst NPVs and their probabilities. What is the value of the most likely NPV outcome? Best (675) 300 250 400 375 10 360.995 Worst (675) 150 200 350 300 10 94.517 Most Likely (675) 205 214.5 377.5 351 10 211.995

SOLUTION: ($000) CFo C01 C02 C03 C04 I NPV

Notice that calculating the most likely outcome requires taking the mean of each cash flow distribution. Probabilities: Best: (.3)(.2)(.45)(.4) = .01080 Worst: (.3)(.35)(.3)(.25) = .00788

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39

7. Using the information from the previous problem, randomly select four NPV outcomes from the data. (Select one cash flow from each year and compute the project NPV and the probability of that NPV implied by those selections.) Do your selections give a sense of where NPV outcomes are likely to cluster? SOLUTION: The solutions should fall between the best and worst possible outcomes of $360,995 and $94,517, and should tend to cluster around the most likely solution of $211,995.

Decision Trees: Example 12-2 (page 532)

8. Northwest Entertainment Inc. operates a multiplex cinema that has nine small theaters in one building. Business has been good lately and management is considering a project that will add five screens at an estimated cost of $3 million. The success of the expansion depends on whether local demand over the next two years will support the additional capacity. Demand is believed to depend on the local economy. An economist at a nearby university has predicted a 90% probability of continued prosperity in the area and a 10% chance of a moderate downturn. Management feels that if prosperity continues the new theaters will generate a profit margin of $2 million in the first year and $3 million in the second. A moderate downturn would produce contributions of $1.5 and $2 million. Northwests cost of capital is 12%. a. Draw a decision tree for the project. b. Calculate the NPV along each path. c. Develop the probability distribution of the projects NPV. d. Calculate the projects expected NPV. e. Make a recommendation on the project with an appropriate comment on risk. SOLUTION: ($000) a. .9 $3,000 .4 $1,000 $1,500 2 $2,000 $3,000 Path 1

b. The NPV along each of the projects paths is: Path 1 NPV = -3000 + 2000(PVF12,1) + 3000(PVF12,2) = -3000 + 2000(.8929) + 3000(.7972) = -3000 + 1785.8 + 2391.6 = 1177.4 Path 2 NPV = -3000 + 1000(PVF12,1) + 1500(PVF12,2) = -3000 + 1000(.8929) + 1500(.7972) = -3000 + 892.9 + 1195.8 = -911.3 c. The projects NPV probability distribution is NPV Probability ($911,300) .1

40 $1,177,400

Chapter 12 .9

d. The expected NPV is the sum of the products of each paths NPV and probability. Expected NPV = $1,177,400 (.9) - $911,300 (.1) = $1,059,660 $91,130 = $968,0530 e. Recommendation: The project has a positive expected NPV, which is substantial relative to the size of the initial investment. This argues strongly for acceptance. There is substantial risk, however, since there is a modest chance of a significant loss. Most managers would probably accept this project unless the underlying business is so weak that the loss would seriously damage it.

More Complex Decision Trees: Examples 12-2 and 12-3 (pages 532 and 534)
9. Work Station Inc. manufactures office furniture. The firm is interested in ergonomic products that are designed to be easier on the bodies of office workers who suffer from aliments such as back and neck pain due to sitting for long periods. Unfortunately customer acceptance of ergonomic furniture tends to unpredictable, so a wide range of market response is possible. Management has made the following two-year, probabilistic estimate of the cash flows associated with the project arranged decision tree format ($000). Path $7,000 .3 $4,000 .7 .6 $6,000 .4 .8 $2,000 .2 $2,400 4 Work Station is a relatively small company, and would be seriously damaged by any project that lost more than $1.5 million. The firms cost of capital is 14%. a. Develop a probability distribution for NPV based on the forecast. I.e., calculate the projects NPV along each path of the decision tree and the associated probability. b. Calculate the projects expected NPV. c. Analyze your results and make a recommendation about the projects advisability considering both expected NPV and risk SOLUTION: a. The NPV along each of the projects four paths and the probability of each of those outcomes is calculated as follows: Path 1 NPV = -6000 + 4000(PVF14,1) + 7000(PVF14,2) $3,000 3 $5,000 2 1

Risk Topics and Real Options in Capital Budgeting = -6000 + 4000(.8772) + 7000(.7695) = -6000 + 3508.8 + 5386.5 = 2895.3

41

Probability = .6 .3 = .18

Path 2 NPV = -6000 + 4000(.8772) + 5000(.7695) = -6000 + 3508.8 + 3847.5 = 1356.3 Path 3 NPV = -6000 + 2000(.8772) + 3000(.7695) = -6000 + 1754.4 + 2308.5 = -1937.1 Path 4 NPV = -6000 +1754.4 + 2400(.7695) = -6000 + 1754.4 + 1846.8 = -2398.8 Probability = .4 .2 = .08 1.00 Probability = .4 .8 = .32 Probability = .6 .7 = .42

b. The expected NPV for the entire project is the sum of the products of each paths NPV and probability. Expected NPV = 2895.3(.18) + 1356.3(.42) 1937.1(.32) 2398.8(.08) = 521.2 + 569.6 619.9 191.9 = 279.0 c. Recommendation: The project has a positive expected NPV, which is quite small relative to the size of the initial investment. This argues weakly for acceptance. However, risk considerations tell another story. Two paths with probabilities totaling 40% have ruinously negative NPVs. That means accepting the project has as much as a 40% probability of seriously damaging or sinking the company. Most rational managers would forego such a project in spite of the positive overall expected NPV.

Abandonment Options: Example 12-5 (page 539)

10. Resolve the last problem assuming Work Station Inc has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2. What is the value of the ability to abandon the project? How does your overall recommendation change? SOLUTION: The ability to abandon the project changes the decision tree as follows: Path $7,000 .3 $4,000 .7 .6 $6,000 $5,000 2 1

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.4 $2,000 $5,000 3 Paths 3 and 4 condense into a new path 3 with the following NPV and probability. Path 3 NPV = 6,000 + 2000(.8772) + 5000(.7695) = 6000 + 1754.4 + 3847.5 = 398.1 Probability = .40 The projects expected NPV is then this outcome combined with those of original paths 1 and 2. (Notice that the probabilities of original paths 1 and 2 and the new path 3 sum to 1.0) Expected NPV = 2895.3(.18) + 1356.3(.42) 398.1(.4) = 521.2 + 569.6 159.2 = 931.6 Compare this probability distribution and expected NPV with those of the last problem. The expected NPV is considerably higher here, it has risen from 279.0 to 931.6, an increase of $652.6. This difference is the least the abandonment option would be worth if Work Station undertakes the project. Perhaps more important, however, is the fact that the projects risk characteristics have changed dramatically. The ability to abandon and recover most of the initial investment has eliminated the potentially ruinous outcomes that were major concerns before. These outcomes have been changed to a 40% probability of a modest loss, which is likely to be acceptable. 11. Vaughn Clothing is considering refurbishing its store at a cost of $1.4 million. Management is concerned about the economy and whether a competitor, Viola Apparel, will open a store in the neighborhood. Vaughn estimates that there is a 60% chance that Viola will open a store nearby next year. The state of the economy probably wont affect Vaughn until the second year of the plan. Management thinks there is a 40% chance of a strong economy and a 60% chance of a downturn in the second year. Incremental cash flows are as follows: Year 1: Viola opens a store - $700,000 Viola doesnt open a store - $900,000 Year 2: Viola opens a store, strong economy - $850,000 Viola opens a store, weak economy - $700,000 Viola doesnt open a store, strong economy - $1,500,000 Viola doesnt open a store, weak economy - $1,200,000 Perform a decision tree analysis of the refurbishment project. Draw the decision tree diagram and calculate the probabilities and NPVs along each of its four paths. Then calculate the overall expected NPV. Assume Vaughns cost of capital is 10%.

Risk Topics and Real Options in Capital Budgeting SOLUTION: A decision tree for Vaughn refurbishment project is as follows ($000): Path $850 .4 $700 .6 .6 $1,400 .4 .4 $900 .6 $1,200 Path 1 NPV = -1400 + 700(PVF10,1) + 850(PVF10,2) = -1400 + 700(.9091) + 850(.8264) = -1400 + 636.37 + 702.44 = -61.19 Path 2 NPV = -1400 + 636.37 + 700(.8264) = -1400 + 636.37 + 578.48 = -185.15 Path 3 NPV = -1400 + 900(.9091) + 1500(.8264) = -1400 + 818.19 + 1239.60 = 657.79 Path 4 NPV = -1400 +818.19 + 1200(.8264) = -1400 + 818.19 + 991.68 = 409.87 Probability = .4 .6 = .24 1.00 Probability = .4 .4 = .16 Probability = .6 .6 = .36 4 $1,500 3 $700 2 1

43

Probability = .6 .4 = .24

The expected NPV for the entire project is the sum of the products of each paths NPV and probability. Expected NPV = -61.19(.24) - 185.15(.36) + 657.79(.16) + 409.87(.24) = -14.69 - 66.65 + 105.25 + 98.37 = 122.58

Real Options: Example 12-4 (page 537)

12. Vaughn Clothing of the previous problem has a real option possibility. Carlson Flooring has expressed an interest in trading buildings with Vaughn after Vaughns is refurbished. Carlson

44

Chapter 12 has offered to reimburse Vaughn for 70% of its refurbishment costs at the end of the first year if they make the trade. Vaughn would then forego all incremental cash flows for the second year. Carlson is willing to keep the option open for one year in return for a non-refundable payment of $150,000 now. Should Vaughn pay the $150,000 to keep the option available?.

SOLUTION: Vaughn would exercise Carlsons option if Viola opened a new store and thus avoid completing paths 1 or 2 in the previous problem. The recovery would be 70% of the initial outlay or ($000) $1,400 x .70 = $980. The decision tree then becomes: Path $1680 .6 $1,550 .4 .4 $900 .6 $1,200 3 $1,500 2 $0 1

Path 1 NPV = -1,550 + 1,680(PVF10,1) = -1,550 + 1,680(.9091) = -1,550 + 1,527.29 = -22.71 Path 2 NPV = -1550 + 900(.9091) + 1500(.8264) = -1550 + 818.19 + 1239.60 = 507.79 Path 3 NPV = -1550 +818.19 + 1200(.8264) = -1550 + 818.19 + 991.68 = 259.87 Probability = .4 .6 = .24 1.00 Probability = .4 .4 = .16

Probability =

.6

The expected NPV for the project including the real option is: Expected NPV = -22.71(.6) + 507.79(.16) + 259.87(.24) = -13.63 + 81.25 + 62.37 = 129.99

Risk Topics and Real Options in Capital Budgeting

45

The value of the real option is this figure less the projects original NPV. Value of Real Option = $129.99 - $122.58 = $7.71 Hence technically Vaughn should spend the money to keep the option open since it adds to the projects NPV. The decision is marginal, however, because the incremental value added is small. 13. Spitfire Aviation Inc. manufactures small, private aircraft. Management is evaluating a proposal to introduce a new high performance plane. High performance aviation is an expensive sport undertaken largely by people who are both young and wealthy. Spitfire sees its target market as affluent professionals under 35, who have made a lot of money in the stock market in recent years. Stock prices have been rising rapidly for some time, so investment profits have been very handsome, but lately there are serious concerns about a market downturn. If the market remains strong, Spitfire estimates it will sell 50 of the new planes per year for five years, each of which will result in a net cash flow contribution of $200,000. If the market turns down, however, only about 20 units a year will be sold. Economists think theres about a 40% chance the market will turn down in the near future. There are also some concerns about the design of the new plane. Not everyone is convinced it will perform as well as the engineering department thinks. Indeed, the engineers have sometimes been too optimistic about their projects in the past. If performance is below the engineering estimate, word of mouth communication among fliers will erode the products reputation, and unit sales after the first year, will be 50% of the forecasts above. Management thinks theres a 30% chance the plane wont perform as well as the engineers think it will. The cost to bring the plane through design and into production is estimated at $15M. Spitfires cost of capital is 12%. a. Draw and fully label the decision tree diagram for the project b. Calculate the NPV and probability along each path. c. Calculate the expected NPV of the project. d. Sketch a probability distribution for NPV. e. Describe the risk situation in words compared to a point estimate of NPV. SOLUTION: a. The decision tree is as follows ($M) Path 10 10 10 10 .7 10 .3 .6 15 .4 .7 4 .3 2 2 2 2 4 b. Path 1 NPV = 15 + 10[PVFA12,5] = 15 + 10(3.6048) = 15 + 36.048 = 21.0 Probability = .6 .7 = .42 4 4 4 4 3 5 5 5 5 2 1

46 Path 2

Chapter 12

= 15 +10[PVF12,1] + 5[PVFA12,4][PVF12,1] = 15 + 10(.8929) + 5(3.0373)(.8929) = 7.5 Probability = .6 .3 = .18 NPV Path 3 NPV = 15 + 4[PVFA12,5] = 15 + 4(3.6048) = 15 + 14.4 = -.6 Probability = .4 .7 = .28 Path 4 = 15 +4[PVF12,1] + 2[PVFA12,4][PVF12,1] = 15 + 4(.8929) + 2(3.0373)(.8929) = -6.0 Probability = .4 .3 = .12 NPV c. Path 1 2 3 4 NPV $21.0M 7.5 .6 6.0 Probability .42 .18 .28 .12 1.00 Product $8.82 1.35 .17 .72 $9.28 = Expected Value

d.

.50 .40 Probabilities .30 .20 .10

$6.0

$0.6 0

$7.5

$21.0

NPV (in $M)

e. The project has an expected NPV of over $9M, which is a likely value for a point-estimated NPV, and would strongly imply accepting the project. The detailed probability distribution shows that theres a significant chance (12%) of a substantial loss ($6M) associated with the project. If management is risk averse, theyre likely to reject a project with that big a loss potential even though the expected NPV is very positive. 14. If Spitfire elects to do the project, what is an abandonment option at the end of year 1 worth if Spitfire can recover $8M of the initial investment into other uses at that time? If the recovery is $13M?

Risk Topics and Real Options in Capital Budgeting

47

SOLUTION: With an abandonment option, the decision tree becomes ($M) Path 10 10 10 10 .7 10 .3 .6 15 .4 8 +4 0 0 0 0 12 The NPVs and probabilities of paths 1 and 2 are the same as in problem 6. For the new third path ($M): Path 3 NPV = 15 + 12[PVF12,1] = 15 + 12(.8929) = 15 + 10.7 = 4.3 Probability = .4 Expected NPV calculations Path 1 2 3 NPV $21.0M 7.5 4.3 Probability .42 .18 .40 1.00 Product $8.82M 1.35M 1.72M $8.45M = Exp Value 3 5 5 5 5 2 1

Hence the abandonment option is worth nothing since it reduces expected NPV. If the recovery is $13M we have: Additional NPV along path 3 Contribution to expected NPV New expected NPV Problem 6 expected NPV Increase in expected NPV $5 $5 .4 .8929 = $1.8 $8.45 + $1.8 = $10.25 $9.28 $10.25 $9.28 = $0.97

Hence the abandonment option is worth just under $1M. 15. The New England Brewing Company produces a super premium beer using a recipe thats been in the owners family since colonial times. Surprisingly, the firm doesnt own its own brewing facilities, but rents time on the equipment of large brewers who have excess capacity. Other small brewers have been doing the same thing lately, so capacity has become difficult to find, and must be contracted for several years in advance. New Englands sales have been increasing steadily, and marketing consultants think theres a possibility that demand will really take off soon. Last years sales generated net cash flows after all

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costs and taxes of $5M. The consultants predict that sales will probably be at a level that will produce net cash flows of $6M per year for the next three years, but they also see a 20% probability that sales could be high enough to generate net cash inflows of $8M per year. Meeting such an increase in demand presents a problem because of the advance contracting requirements for brewing capacity. Unless New England arranges for extra facilities now, theres a 70% chance that brewing capacity wont be available if the increased demand materializes. An option arrangement is available with one of the large brewers under which it will hold capacity for New England until the last minute for an immediate, nonrefundable payment of $1M. New Englands cost of capital is 9%. a. Draw a decision tree reflecting New Englands cash flows for the next three years without the option and calculate the expected NPV of operating cash flows. (Note that theres no need to include an initial outlay because were dealing with ongoing operations.) b. Redraw the decision tree to include the capacity option as a real option in your calculations. What is its value? Should it be purchased? c. Does the real option reduce New Englands risk in any way? SOLUTION: a. The decision tree without the option is as follows: .3 .2 .7 .8 $6 $6 $6 $6 $6 $6 $8 $8 $8

NPV = (.2)(.3)($8M)[PVFA9,3] + (.2)(.7)($6M)[PVFA9,3] +(.8)($6M)[PVFA9,3] = $.48M(.7722) + $.84M(.7722) + $4.8M(.7722) = $6.12M(.7722) = $4.73M b. The capacity option changes the decision tree to the following: $8 $8 $8 .2 ($1) .8 $6 $6 $6 NPV = $1 + (.2)($8M)[PVFA9,3] + (.8)($6M)[PVFA9,3] = $1 + $1.6M(.7722) + $4.8M(.7722) = $1 + $6.4M(.7722) = $1 + $4.94M = $3.94M The capacity options value is the increase in expected NPV it generates before consideration of its own cost. In this case thats $4.94M $4.73M = $.21M Since thats substantially less than the $1M cost of the option, New England would be better off not buying it. c. Real options generally have favorable risk effects when they reduce the probability or magnitude of losses. In this case the option doesnt do that. Rather it guarantees the ability to take advantage of a potential opportunity. That generally wouldnt be viewed as reducing risk.

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Risk Adjusted Rates SML: Example 12-6 (page 546)

16. Hudson Furniture specializes in office furniture for self-employed individuals who work at home. Hudsons furniture emphasizes style rather than utility, and has been quite successful. The firm is now considering entering the more competitive industrial furniture market where volumes are higher but pricing is more competitive. A $10 million investment is required to enter the new market. Management anticipates positive cash flows of $1.7 million annually for eight years if Hudson enters the field. An average stock currently earns 8%, and the return on treasury bills is 4%. Hudsons beta is .5 while that of an important competitor that operates solely in the industrial marketis 1.5. Should Hudson consider entering the industrial furniture market?

SOLUTION: ($M) First calculate the appropriate discount rate for the project using the pure play competitors beta. kx = kRF + (kM - kRF)bX = 4 + (8 - 4) 1.5 = 10% Use a calculator to arrive at the projects NPV CFo (10) C01 1.7 F01 8 I 10 NPV (.930625) Since the NPV is negative, Hudson should not enter the new market. Its important to notice that the opposite result would have been obtained using Hudsons own beta to calculate a risk adjusted return as follows: kx = kRF + (kM - kRF)bX = 4 + (8 - 4) .5 = 6% and CFo (10) C01 1.7 F01 8 I 6 NPV .5566 So a positive NPV would have indicated going ahead with the new venture, probably an incorrect result. 17. Crest Concrete Inc. has been building basements and slab foundations for new homes in La Crosse, Wisconsin for more than 20 years. However, new home sales have slowed recently and residential construction work is hard to get. As a result, management is considering a venture into commercial construction. Although Crest would still be pouring concrete in commercial building, almost everything else about the business differs substantially from homebuilding which is all the firm has done until now. The local commercial concrete business is dominated by two firms. Readi-Mix Inc., and Toddy Concrete Inc. Readi-Mix has been in business for 50 years, has a market share of 70%, and a beta of 1.3. Toddy has been in the area for only five years and has a beta of 2.4. Crests own beta is .9 and its cost of capital is 9.3%. Both of these were developed during a long period in which the

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housing market was prosperous and growing steadily. The stock market is currently returning 11% and treasury bills are yielding 4.2%. Crest will have to spend $950,000 to get started in the commercial field, and expects net cash inflows of $250,000 in the first year, $400,000 in the second year and $700,000 in the third. Should Crest give commercial construction a try? SOLUTION The new project is relatively risky for Crest, so it should be evaluated using a risk adjusted rate rather than the firms own cost of capital, which reflects a low risk business (developed during a stable period). Well apply the Capital Asset Pricing Model to a pure play company in the field to get a reasonable risk adjusted rate. It makes sense to use Toddy rather than Readi-Mix because Crest would initially be a small player and not a market leader like Readi-Mix. Applying the CAPM we have k = kRF + (kM-kRF)b Toddy = 4.2% + (11% - 4.2%)2.4 = 20.52% Then use a financial calculator as follows: CFo (950000) C01 250000 F01 1.0 C02 400000 F02 1.0 C03 700000 F03 1.0 Press NPV I 20.52 Result: NPV (67,308) This implies the project should be rejected. Now compute the projects NPV using Crests 9.3% cost of capital to get a value of $149,644. Notice that a reasonable consideration of risk implies the project should be rejected while the traditional approach gives a definite signal to accept. 18. Illinois Fabrics Inc. makes upholstery thats used in high-quality furniture, largely chairs and sofas. Illinois has traditionally sold their fabric to manufacturers who use it to cover furniture frames they produce. These manufacturers then wholesale the finished product to furniture stores. Management has analyzed the finished chairs and sofas of several manufacturers and found that the highest value element they contain is the Illinois fabric. They further found that generally the frames were shoddily produced. Illinois VP of Manufacturing, Harrison Flatley, has proposed starting a new business called Illinois Furniture which will produce and market the end product using the fabric the firm already manufactures. Harrison has put together a proposal to start such a venture which results in a steady stream of cash income of $5 million per year after an initial investment of $25 million to be spent on manufacturing facilities and the development of a sales relationship with retailers. The analysis comes up with an NPV for the project assuming the income stream is a perpetuity and taking its present value at Illinois 10% cost of capital. NPV = -$25M + $5M / .10 = -$25M + $50M = $25M Top management likes the idea but is concerned about risk in two areas. First, furniture manufacturing seems to be a riskier business than making fabric as manufacturing firms are always entering and leaving the industry. The average beta of the publicly traded end product manufacturers is a relatively high 1.9. By contrast, Illinois beta is .9.

Risk Topics and Real Options in Capital Budgeting

51

Second, management fears that an economic downturn would impact a new business more seriously than it would the existing competitors. Management fears that theres a 40% chance of a downturn in the near future which would reduce Harrisons income projections by 20%. Re-analyze Harrisons proposal and make a recommendation to management. Treasury bills are yielding 4% and the S&P 500 index is yielding 10%. SOLUTION: First develop the appropriate risk adjusted discount rate for analysis using the SML kX = kRF + (kM kRF)bX = 4 + (10 4)1.9 = 4 + 11.4 = 15.4% Then recalculate the projects NPV at the $5M income level NPV = -$25M + $5M / .154 = -$25M + $32.5M = $7.5M Next calculate the NPV at a 20% lower income level, i.e., $5M x .8 = $4M NPV = -$25M + $4M / .154 = -$25M + $26M = $1M Hence a probability distribution of risk adjusted outcomes is Economy Good .6 Down .4 Probability NPV x $7.5M = $4.5M x $1.0M = $0.4M $4.9M

Hence the projects risk adjusted NPV has an expected value of about $4.9M without too much chance of being above $7.5M or below $0.4M. This passes the NPV decision rule and doesnt involve a chance of a crippling loss which argues in favor of acceptance. Nevertheless, the NPV is modest relative to the size of the investment required. The recommendation should therefore be a less than enthusiastic approval as long as there arent better uses for the $25M. Its theoretically important to notice that our procedure has not double counted risks. The risk adjusted discount rate deals with market risk which does not include the extra 20% income decline due to an economic downturn. That response to an economic downturn is an incremental, business specific risk incurred solely by the venture because it will be a new entrant and therefore more vulnerable to economic conditions than the existing competitors whose betas average 1.9.