13 Risk Analysis and Real Options

13 Risk Analysis and Real Options - 13 - 1 CHAPTER 13 Risk...

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13 - 1 CHAPTER 13 Risk Analysis and Real Options Types of risk: stand-alone, corporate, and market Project risk and capital structure Risky outflows Effects of abandonment possibilities Real options Optimal capital budget
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13 - 2 What does “risk” mean in capital budgeting? Uncertainty about a project’s future profitability . Measured by σ NPV , σ IRR , beta. Will taking on the project increase the firm’s and stockholders’ risk?
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13 - 3 Is risk analysis based on historical data or subjective judgment? Can sometimes use historical data, but generally cannot. So risk analysis in capital budgeting is usually based on subjective judgments.
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13 - 4 What three types of risk are relevant in capital budgeting? Stand-alone risk Corporate risk Market (or beta) risk
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13 - 5 How is each type of risk measured, and how do they relate to one another? 1. Stand-Alone Risk: The project’s risk if it were the firm’s only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the σ or CV of NPV, IRR, or MIRR.
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13 - 6 0 E(NPV) Probability Density Flatter distribution, larger σ , larger stand-alone risk. Such graphics are increasingly used by corporations. NPV
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13 - 7 2. Corporate Risk: Reflects the project’s effect on corporate earnings stability. Considers firm’s other assets (diversification within firm). Depends on: project’s σ , and its correlation with returns on firm’s other assets. Measured by the project’s corporate beta.
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13 - 8 Profitability 0 Years Project X Total Firm Rest of Firm 1. Project X is negatively correlated to firm’s other assets. 2. If r < 1.0, some diversification benefits. 3. If r = 1.0, no diversification effects.
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13 - 9 3. Market Risk: Reflects the project’s effect on a well-diversified stock portfolio. Takes account of stockholders’ other assets. Depends on project’s σ and correlation with the stock market. Measured by the project’s market beta.
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13 - 10 How is each type of risk used? Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Therefore, corporate risk is also relevant.
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13 - 11 Stand-alone risk is easiest to measure, more intuitive . Core projects are highly correlated with other assets , so stand-alone risk generally reflects corporate risk. If the project is highly correlated with the economy , stand-alone risk also reflects market risk.
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13 - 12 What is sensitivity analysis? Shows how changes in a variable such as unit sales affect NPV or IRR . Each variable is fixed except one.
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13 Risk Analysis and Real Options - 13 - 1 CHAPTER 13 Risk...

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