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 don’t 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

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 couldn’t 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...