Chap14_2009

Chap14_2009 - Chapter 14 Risk and Managerial(Real Options in Capital Budgeting Learning Objectives After studying Chapter 14 you should be able to

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Chapter 14 Risk and Managerial (Real) Options in Capital Budgeting

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Learning Objectives After studying Chapter 14, you should be able to: Define the "riskiness" of a capital investment project. Understand how cash-flow riskiness for a particular period is measured, including the concepts of expected value, standard deviation, and coefficient of variation. Describe methods for assessing total project risk, including a probability approach and a simulation approach. Judge projects with respect to their contribution to total firm risk (a firm-portfolio approach). Understand how the presence of managerial (real) options enhances the worth of an investment project. List, discuss, and value different types of managerial (real) options.
• The Problem of Project Risk • Total Project Risk • Contribution to Total Firm Risk: Firm- Portfolio Approach • Managerial (Real) Options Topics

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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 An Illustration of Total Risk (Discrete Distribution)
.40 .05 .25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow (\$) Probability Distribution of Year 1 Cash Flows (Proposal A)

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CF 1 P 1 ( CF 1 )( P 1 ) \$ -3,000 .05 \$ -150 1,000 .25 250 5,000 .40 2,000 9,000 .25 2,250 13,000 .05 650 = 1.00 CF 1 = \$5,000 Expected Value of Year 1 Cash Flows (Proposal A)
( CF 1 )( P 1 ) ( CF 1 - CF 1 ) 2 ( P 1 ) \$ -150 ( -3,000 - 5,000 ) 2 ( .05 )= 3,200,000 250 ( 1,000 - 5,000 ) 2 ( .25 )= 4,000,000 2,000 ( 5,000 - 5,000 ) 2 ( .40 )= 0 2,250 ( 9,000 - 5,000 ) 2 ( .25 )= 4,000,000 650 ( 13,000 - 5,000 ) 2 ( .05 )= 3,200,000 \$5,000 14,400,000 Variance of Year 1 Cash Flows (Proposal A)

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Summary of Proposal A Standard deviation = SQRT (14,400,000) = \$3,795 Expected cash flow = \$5,000 Coefficient of Variation (CV) = \$3,795 / \$5,000 = 0.759 CV is a measure of relative risk and is the ratio of standard deviation to the mean of the 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 An Illustration of Total Risk (Discrete Distribution)

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.40 .05 .25 Probability -3,000 1,000 5,000 9,000 13,000 Cash Flow (\$) Probability Distribution of Year 1 Cash Flows (Proposal B)
CF 1 P 1 ( CF 1 )( P 1 ) \$ -1,000 .05 \$ -50 2,000 .25 500 5,000 .40 2,000 8,000 .25 2,000 11,000 .05 550 = 1.00 CF 1 =\$5,000 Expected Value of Year 1 Cash Flows (Proposal B)

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( CF 1 )( P 1 ) ( CF 1 -
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This note was uploaded on 07/06/2009 for the course BUS BAM314 taught by Professor Na during the Spring '09 term at 東京大学.

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Chap14_2009 - Chapter 14 Risk and Managerial(Real Options in Capital Budgeting Learning Objectives After studying Chapter 14 you should be able to

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