session 7 risk analysis

8/3/2019 Session 7 Risk Analysis

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Capital Budgeting - Risk Analysisand Real Options


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What does risk mean in

capital budgeting?

Uncertainty about a projects futureprofitability.

Measured by WNPV,WIRR, beta.

Will taking on the project increasethe firms and stockholders risk?


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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 onsubjective judgments.


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What three types of risk are relevant in

capital budgeting?

Stand-alone risk

Corporate risk

Market (or beta) risk


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How is each type of risk measured, and

how do they relate to one another?

1. Stand-Alone Risk:

The projects risk if it were the firmsonly asset and there were noshareholders.

Ignores both firm and shareholderdiversification.

Measured by the W or CV ofNPV,IRR, or MIRR.


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2. Corporate Risk:

Reflects the projects effect oncorporate earnings stability.

Considers firms other assets

(diversification within firm).Depends on:

projects W, and

its correlation wit

hreturns onfirms other assets.

Measured by the projectscorporate beta.


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3. Market Risk:

Reflects the projects effect on awell-diversified stock portfolio.

Takes account of stockholdersother assets.

Depends on projects W andcorrelation with the stock market.

Measured by the projects marketbeta.


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How is each type of risk used?

Market risk is theoretically best in

most situations.However, creditors, customers,

suppliers, and employees are moreaffected by corporate risk.

Therefore,corporate risk is alsorelevant.


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Stand-alone risk is easiest tomeasure, more intuitive.

Core projects are

high

lycorrelated with other assets, sostand-alone risk generally reflectscorporate risk.

If the project is highly correlatedwith the economy, stand-alonerisk also reflects market risk.


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What is sensitivity analysis?

Shows how changes in a variablesuch as unit sales affect NPV orIRR.

Each variable is fixed except one.Change this one variable to see

the effect on NPV or IRR.

Answers what if questions, e.g.What if sales decline by 30%?


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What are the weaknesses of

sensitivity analysis?

Does not reflect diversification.

Says nothing about the likelihoodof change in a variable, i.e. a steepsales line is not a problem if sales

wont fall.

Ignores relationships amongvariables.


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Why is sensitivity analysis useful?

Gives some idea of stand-alone

risk. Identifies dangerous variables.

Gives some breakeven

information.


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What is scenario analysis?

Examines several possible

situations, usually worst case,most likely case, and best case.

Provides a range of possible

outcomes.


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How do correlation and W affect

a projects contribution to

corporate risk?

IfWP

is relatively high, then projectscorporate risk will be high unlessdiversification benefits are significant.

If project cash flows are highly cor-

related with the firms aggregate cashflows, then the projects corporate riskwill be high ifWP is high.


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Would a core project in the furniture

business be highly correlated with thegeneral economy and thus with the

market?

Probably. Furniture is a deferrableluxury good, so sales are probably

correlated withbut more volatilethan the general economy.


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Would correlation with the

economy affect market risk?

Yes.

High correlation increasesmarket risk (beta).

Low correlation lowers it.


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Should subjective risk factors be

considered?

Yes. A numerical analysis may notcapture all of the risk factors inherentin the project.

For example,if th

e projecth

as th

epotential for bringing on harmfullawsuits, then it might be riskierthana standard analysis would indicate.


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Are there any problems with scenario

analysis?

Only considers a few possible out-

comes.Assumes that inputs are perfectly

correlated--all bad values occurtogether and all good values occurtogether.

Focuses on stand-alone risk, althoughsubjective adjustments can be made.


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What is a simulation analysis?

A computerized version of scenario

analysis which uses continuousprobability distributions.

Computer selects values for each

variable based on given probabilitydistributions.

(More...)


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NPV and IRR are calculated.

Process is repeated many times

(1,000

or more).End result: Probability

distribution ofNPV and IRR basedon sample of simulated values.

Generally shown graphically.


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What are the advantages of simulation

analysis?

Reflects the probabilitydistributions of each input.

Shows range ofNPVs, the

expected NPV,WNPV, and CVNPV.Gives an intuitive graphof the risk

situation.


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What are the disadvantages of

simulation?

Difficult to specify probability

distributions and correlations.

If inputs are bad, output will be bad:Garbage in, garbage out.

May look more accurate than it reallyis.

(More...)


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Sensitivity, scenario, and simulationanalyses do not provide a decisionrule. They do not indicate whether a

projects expected return is sufficientto compensate for its risk.

Sensitivity, scenario, and simulation

analyses all ignore diversification.Thus they measure only stand-alonerisk, whichmay not be the mostrelevant risk in capital budgeting.


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Advantages and disadvantages of

applying the CAPM in capital budgeting

Advantages:

A projects market risk is the mostrelevant risk to stockholders,hence to determine the effect of

the project on stock price.

It results in a definite hurdle ratefor use in evaluating the project.


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Disadvantages:

It is virtually impossible to

estimate betas for many projects.

People sometimes focus onmarket risk to the exclusion of

corporate risk, and this may be amistake.


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Real Options

Real options occur when managersh

ave th

e opportunity to influence th

ecash flows of a project after theproject has been implemented.

Real options also are called:

Managerial options.

Strategic options.


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How do real options increase the

value of a project?

Real options allow managers toavoid negative project cash flows ormagnify positive project cash flows.

Increases size of expected cash

flows.

Decreases risk of expected cashflows.


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How is the DCF method affected?

(1) Its easy to quantify the increase inthe size of the expected cash flows.

(2) Its very hard to quantify thedecrease in the risk of the expectedcash flows.

(3) The correct cost of capital cannotbe identified, so the DCF methoddoesnt work very well.


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Types of Real Options

Flexibility options

Abandonment options

Options to contract or temporarilysuspend operations

Options to expand volume of product

Options to expand into newgeographic areas (More...)


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Options to add complementaryproducts

Options to add successivegenerations of the same product

Options to delay


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What attributes increase the value of

real options?

All real options have a positive value.

Even if its not possible to determinea quantitative estimate of a realoptions value, its better to have a

qualitative estimate than to ignorethe real option.

(More...)


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Real options are more valuable if:

They have a long time until youmust exercise them.

The underlying source of risk isvery volatile.

Interest rates are high.


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Presented by:

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38

22

02

47

13


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Presented by:

JAI DOSHI

RAHUL CHHABRIA

KUSHAAL SARAF

DHIREN MODI

AVNEETH DANG

TARANG NAGDA

session 7 risk analysis

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