Capital Budgeting and Risk

Introduction
• Capital budgeting decisions require that managers analyze the
following factors for each project they consider:
• Future cash flows,
• The degree of uncertainty of these future cash flows, and
• The value of these future cash flows considering their uncertainty.
• Managers incorporate risk into their calculations in one of two
ways: (1) by discounting future cash flows using a higher discount
rate, the greater the cash flow’s risk, or (2) by estimating risk-
adjusted cash flows.
Measuring project’s stand-alone risk
• Statistical Measure of Cash Flow Risk:
• Range
• Standard Deviation
• Coefficient of Variation
• Once we know how to calculate and apply these statistical
measures, all we need are the probability distributions of
the project’s future cash flows
• Three approaches to incorporate risks in cash flows:
• Sensitivity analysis
• Scenario analysis
• (Monte Carlo) Simulation
Sensitivity & Scenario Analyses
• Estimates of cash flows are based on assumptions about
the economy, competitors, consumer tastes and
preferences, construction costs, and taxes, among a host
of other possible assumptions.
• One can analyze the sensitivity of cash flows to change in
the assumptions by reestimating the cash flows for
different scenarios.
• Sensitivity analysis is a method of looking at the possible
outcomes, given a change in one of the factors in the
analysis.
• Scenario analysis is a method of looking at the possible
outcomes under different probabilistic scenario of state of
the economy or industry.
Simulation Analysis
• Sensitivity analysis becomes unmanageable if we change
several factors at the same time.
• Simulation analysis allows the financial manager to
develop a probability distribution of possible outcomes,
given a probability distribution for each variable that may
change.
• However, simulation analysis looks at a project in
isolation, and ignores the effects of diversification for the
owners’ personal portfolio.
Monte Carlo Simulation
• Set the precise model of the project laying down the
variables that affect your cash flows.
• Specify probabilities (or range of outcome) for each
variable.
• Simulate the cash flows many times (e.g. 10000 runs)
• You get the distributions of project cash flows. Compute
the expected cash flows.
• Finally, using the applicable discount factor, discount the
expected cash flows to get NPV.
Scenario Analysis: A case study
•Financial Appraisal of Koyali-
Ratlam Pipeline
Justification
• Better evacuation of MS, SKO and HSD ex-Koyali.
• Reduce logistic cost and help in positioning IOC’s
products in Central India at competitive cost .
• The pipeline would act as an entry barrier to private
oil companies from laying Central India pipeline.
Financial Appraisal
• Laying down of pipeline would involve:
• Upfront investment- Rs. 322.92 crore (for 2MMTPA
capacity in phase I)
• Annual opex-Rs. 9.97 crore
• Augmentation of refining capacity at Koyali in line with
demand requirements
• Better throughput and savings therefrom.
Three different scenario
• Scenario-I
• Demand numbers at the levels as originally furnished by
Planning Department. Gives and takes escalated by the growth
rates adopted for demand.
• Scenario- II
• Demand numbers for IOCL and associates lowered. Gives and
takes as per scenario-I.
• Scenario-III
• Demand numbers same as scenario-II. Gives separately
determined.
IRR under various scenarios

IRR(%)

Project IRR Equity IRR

Scenario I 15.01 20.96

Scenario II 14.61 20.89

Scenario III 11.10 14.97

Sensitivity Analysis
Case Scenario I Scenario II Scenario III

Project IRR(%)
Increase in capital 13.63 13.19 9.76
cost by 10%
Increase in opex 14.80 14.40 10.88
by 10%

Equity IRR(%)

Increase in capital 18.49 18.34 12.61

cost by 10%
Increase in opex 20.62 20.51 14.58
by 10%
Real Options: Method to value flexibility
• One of the fundamental insights of modern finance theory is that
options have value.
• The phrase “We are out of options” is surely a sign of trouble.
• Because corporations make decisions in a dynamic environment, they
have options that should be considered in project valuation.
Real Options
• The Option to Expand
• Has value if demand turns out to be higher than expected
• The Option to Abandon
• Has value if demand turns out to be lower than expected
• The Option to Delay
• Has value if the underlying variables are changing with a favorable trend
Discounted CF and Options
• We can calculate the market value of a project as the sum
of the NPV of the project without options and the value of
the managerial options implicit in the project.
M = NPV + Opt

A good example would be comparing the desirability

of a specialized machine versus a more versatile
machine. If they both cost about the same and last
the same amount of time, the more versatile machine
is more valuable because it comes with options.
The Option to Abandon: Example
• Suppose we are drilling an oil well. The drilling rig
costs $300 today, and in one year the well is either a
success or a failure.
• The outcomes are equally likely. The discount rate is
10%.
• The PV of the successful payoff at time one is $575.
• The PV of the unsuccessful payoff at time one is $0.
The Option to Abandon: Example
Traditional NPV analysis would indicate rejection of the project.

Expected = Prob. × Successful + Prob. × Failure

Payoff Success Payoff Failure Payoff

Expected
= (0.50×$575) + (0.50×$0) = $287.50
Payoff

$287.50
NPV = –$300 + = –$38.64
1.10
The Option to Abandon: Example
Traditional NPV analysis overlooks the option to abandon.

Success: PV = $575

Drill Sit on rig; stare

at empty hole:
 $300 PV = $0.
Failure

Do not Sell the rig;

NPV  $ 0 salvage value
drill
= $250
The firm has two decisions to make: drill or not, abandon or stay.
The Option to Abandon: Example
 When we include the value of the option to abandon, the
drilling project should proceed:

Expected = Prob. × Successful + Prob. × Failure

Payoff Success Payoff Failure Payoff

Expected
= (0.50×$575) + (0.50×$250) = $412.50
Payoff

$412.50
NPV = –$300 + = $75.00
1.10
Valuing the Option to Abandon
• Recall that we can calculate the market value of a
project as the sum of the NPV of the project
without options and the value of the managerial
options implicit in the project.

M = NPV + Opt
$75.00 = –$38.64 + Opt
$75.00 + $38.64 = Opt
Opt = $113.64
The Option to Delay: Example
Cost Cost PV PVNPV tNPVNPV
Year Year t 0
0 $0 20,000
$ 20,000 $ 25,000
$ 25,000 $ 5,000
$ 5,000 $ 5,000
1 $1 18,000
$ 18,000 $ 25,000
$ 25,000 $ 7,000
$ 7,000 $ 6,364
2 $2 17,100
$ 17,100 $ 25,000
$ 25,000 $ 7,900
$ 7,900 $ 6,529 $7,900
$6,529 
3 $3 16,929
$ 16,929 $ 25,000
$ 25,000 $ 8,071
$ 8,071 $ 6,064 (1.10) 2
4 $4 16,760
$ 16,760 $ 25,000
$ 25,000 $ 8,240
$ 8,240 $ 5,628
• Consider the above project, which can be undertaken in any of the
next 4 years. The discount rate is 10 percent. The present value of
the benefits at the time the project is launched remains constant at
$25,000, but since costs are declining, the NPV at the time of launch
steadily rises.
• The best time to launch the project is in year 2—this schedule yields
the highest NPV when judged today.