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.
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.
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.