Risk Topics and Real Options in Capital Budgeting
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 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, decision tree analysis, 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 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.

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