Chapter 14 Risk and Managerial Options in Capital Budgeting 14-1
14-1 Chapter 14 Risk and Managerial Options in Capital Budgeting
Risk and Managerial Options in Capital a The Problem of Project Risk o Total Project Risk a Contribution to Total firm risk Firm-Portfolio Approach a Managerial Options 14-2
14-2 Risk and Managerial Options in Capital Budgeting The Problem of Project Risk Total Project Risk Contribution to Total Firm Risk: Firm-Portfolio Approach Managerial Options
An llustration of total risk Discrete Distribution) ANNUAL CASH FLOWS: YEAR 1 PROPOSALA 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
14-3 An Illustration of Total Risk (Discrete Distribution) 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
Probability Distribution of year 1 Cash Flows Proposal A 40 25 05 -3,0001,0005,0009,00013,000 Cash Flow() 14-4
14-4 Probability Distribution of Year 1 Cash Flows .40 .05 .25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow ($) Proposal A
Expected Value of Year 1 Cash Flows(Proposal CF1 P (cF1)() $-3,000 05 $-150 1,000 25 250 5.000 40 2.000 9.000 25 2,250 13,000 05 650 ∑=1.00CF1=$5,000 14-5
14-5 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 =1.00 CF1=$5,000 Expected Value of Year 1 Cash Flows (Proposal A)
Variance of year 1 Cash Flows(Proposal) (cF() (cF1·cFP(P) $-150(-3,000·5,00)2(05) 250(1,0005,0002(25) 2,000 (5,000-5,000)2(40 2,250(9,000-50002(25 650 (13,000-5,000)2(05) s5,000 14-6
14-6 (CF1 )(P1 ) (CF1 - CF1 ) 2 (P1 ) $ -150 ( -3,000 - 5,000) 2 (.05) 250 ( 1,000 - 5,000) 2 (.25) 2,000 ( 5,000 - 5,000) 2 (.40) 2,250 ( 9,000 - 5,000) 2 (.25) 650 (13,000 - 5,000) 2 (.05) $5,000 Variance of Year 1 Cash Flows (Proposal A)
Variance of year 1 Cash Flows(Proposal) (CF)() (CF, -CF )2(P) $-150 3,200.000 250 4.000.000 2,000 0 2,250 4.000.000 650 3,200,000 s5,000 14,400,000 14-7
14-7 Variance of Year 1 Cash Flows (Proposal A) (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
Summary of Proposal A The standard deviation E sQRT(14,400000)=$3,795 The expected cash flow E $5,000 14-8
14-8 Summary of Proposal A The standard deviation = SQRT (14,400,000) = $3,795 The expected cash flow = $5,000
An llustration of total risk Discrete Distribution) 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
14-9 An Illustration of Total Risk (Discrete Distribution) 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
Probability Distribution of year 1 Cash Flows Proposal B 40 25 05 -3,0001,0005,0009,00013,000 Cash Flow() 14-10
14-10 Probability Distribution of Year 1 Cash Flows .40 .05 .25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow ($) Proposal B
