Risk in Capital Budgeting, Accountancy and Financial management Video Lecture | Accountancy and Financial Management - B Com

hi this is professor Nugent and today
I'm talk about chapter 12 which deals
with risk in relationship to capital
budgeting there's a couple learning
goals that we want to discuss as we're
moving through this one big influence in
this chapter is of course risk and how
to measure risk appropriately to analyze
capital budgets now looking at different
projects different projects have
different cash inflows and cash outflows
so we can use to narrow analysis and
simulations to help us to deal with
quantify understand risk we can are
going to review the unique risks then
multi-national companies face I'm going
to talk about our ad RS which are risk
adjusted portfolio discounts which we
use to help make projects more
comparable when they have different
risks and we're also going to be using
annualized net present values a and t
v--'s which help to equalize and make
projects comparable to have different
time frames for the cash flows we're
going to look at the role of real
options in selecting projects for
capital budgeting and capital rationing
okay
so let's start out with risk in the
capital budgeting so when we talked
about chapters 10 and in chapters 11 in
this textbook we're just introducing the
capital budgeting techniques in capital
budgeting cash flows just the this the
routine basic dimensions of those
concepts in this chapter we introduce
risk so we want to get a little bit
closer to the real world and we have to
assume that all investments and all
projects have different levels of risk
and risk is a very difficult thing to
quantify but the more I can quantify the
risks the better able I will be to
choose projects that meet my company's
goals and needs so in you know we can't
assume that all projects are equally
risky which we were doing in chapters 10
and 11 you know so the acceptance of any
project you know will change as the
risks associated with the project change
now
it's very common for managers to use
their experience overall to understand
and accept what the risks are over of a
project and taking on exceptionally
risky projects can affect a lot of
different areas of the company besides
that one project project for example the
overall creditworthiness of the country
company can be affected and then overall
raised across the barring for all future
projects so that's why risk is a key
consideration in assembling your
projects that go into your capital
budget now you will remember from
chapters 10 and 11 we had this project
day in project B which has this series
of five cash flows so project a has
equal series of five $14,000 cash flows
for a total of seventy thousand three
four five yes and then project B had an
unequal flow of cash flows twenty eight
thousand twelve ten ten and ten also 70
thousand so this is something that we
looked at in calculating the present
value for these two projects in the
previous chapter we know that in project
day the net present value is eleven
thousand and project B in the net
present value is ten thousand nine
hundred and making project a based on
that present value of the projects we
should accept and it should be noted
that both these products have different
initial investments now what if these
projects are of different risk so of
these two projects if project a happen
to be much riskier than project B then
if we're only talking about you know a
hundred and fifty thousand dollars or
whatever between one hundred fifty
dollars between the two projects then
probably should go with the less riskier
project you know so it's not always
about who makes the maximum money but we
want to look at take into consideration
risk so if project B is risk free over
project a it's a huge amount of risk of
that not happening we should go a
project bait and that's the
consideration we're trying to put in
here so a behavioral approach deal
with risk risk and cash inflow so the
risk of a project is that the cash
inflows that you're expecting will won't
develop so we can use these behavioral
approaches to get a feel for the level
of the project's risk so other
approaches can quantify and measure the
project's risk in a way that we can
monetize so let's talk about risk in the
capital budgeting they refers to the
uncertainty around the cash flow so cash
flows is what we're at risk of not
receiving the cash flows that we're
projecting so there is going to be a
degree of variability and any project
where we've outlined the future cash
flow so it's only a projection so as the
project gets out further in the future
things become even less predictable and
risk to increase even more so length of
time of the project is also going to be
related to the risk now we remember this
formula should look familiar below so
this is a net present value formula that
we've used in previous chapters so let's
look at this example here so the
treadmill attire company the tire
retailer with 10% cost of capital is
considering investing in project and -
we actually exclusive projects remember
mutually exclusive means we're going to
pick one or the other but not we can't
pick both so each require $10,000
initial investment and both are expected
to provide a constant annual cash flows
over the next 16 the next 15 years of
their life so the project says equal
lives which helps our make our
comparisons a little bit easier so for
either project of course will be
acceptable when the net present value is
greater than zero
so using Excel we can calculate the
break-even point so a break-even in cash
flow so this would tell us at what
amount of cash flow per year would we
break even on the initial investment so
if we have across the capital of 10
percent 15 years of cash flows initial
investment of 10000 which we shows-
because it's a present value that would
if we use the payment formula now we
calculate a break a break even cash flow
of 1314 and seventy four cents so if a
cash flow is greater than 1314 dollars
this is this is a approvable project in
the cash flow the project generates is
less than the breakeven then we'll be
losing money on the project so this is
another way of looking at whether
projects acceptable or not is to develop
the break-even cash flow amount and we
could use the Excel function formula
payment to calculate and something that
we'll be doing in the Excel project for
this chapter now so if we look at you
know for the projects that we were just
talking about they must have an annual
cash flow of at least rounded up of $13
1315 dollars so the risk can be assessed
by determining the probability of the
project's cash flows you know will equal
or exceed the break-even point so assume
the statistical analysis rolls in the
following the probability of the cash
flow for project day is greater than
1315 is 100% and the probability of cash
flow B being greater than 1315 dollars
only 65% so here we see the project day
you know both projects have a positive
net present value but well there's only
65% chance of project B will have that
positive net present value or project
day is 100% so it makes your choice
simple we would just pick project day
because there's a better than the lower
risk so if we talk about scenario
analysis this is again a behavioral
approach where we're going to use
several possible different outcomes
which we'll call scenarios to obtain a
sense of the variability of returns
measured by the net present value so in
you know in the capital budgeting
process the most common scenario
approaches to estimate when that present
value is is usually the three a
three-tier approach where we have
pessimistic most likely and optimistic
so which you can also think of was worst
expected in best scenarios so that you
can have many more categories but this
is just the baseline would be these
three categories so the range can be
determined by subtracting the you know
pessimistic outcome from the optimistic
outcome linking in a range of a net
present value so here we could see that
for project a here are three cash flows
pessimistic most likely optimistic and
the range is a thousand or twenty five
hundred minus fifteen hundred on project
B which is riskier we have a pessimistic
of zero two thousand four thousand and
the range being four thousand which is
four thousand minus zero so the bigger
the range the higher the variability or
risk now if we calculate the net present
values we'll see that we get fourteen
hundred fifty two and nine thousand a
range of seven thousand and net present
values and here we have a negative ten
thousand five thousand twenty thousand
which is a thirty thousand dollar range
again this is why one of the outcomes is
potentially a loss so that's why this
project B has a lower percentage of
outcomes of the net present value higher
than 1315 now a simulation is similar
simulations were taking scenario
analysis and running in through a model
so it's a statistic it's more
statistical based behavioral approach
where we're going to predetermine
probability distributions with a set of
random numbers related to the riskier
outcomes to estimate risk so by trying
various cash flow components together
with a mathematical model we could run
through a number of a huge number of
scenarios in a simulation
get a sort of a detailed output of all
of all the possibilities within the
realm of this project so a simulation
can be you know as simple as this model
right here where generate random number
probability cash flow and then net
present value and so and this is model
just kind of repeats itself over and
over and over
we're just generating random numbers we
can make a tolerance or set up a range
of numbers that we want to put in the
scenario from the least likely the most
likely and then run them through to get
an overall idea of all the possible
outcomes then we can graph them in the
chart to see you know where they lie on
some sort of Scalla graph so now a Monte
Carlo method is based on the scenario
and simulation models and this is
something that you you know is very
popular today and was made possible from
the amount the large amount of computer
processing power we have today so the
Monte Carlo simulation is a program that
the goal is to randomly generate huge
amounts of uncertain variables to go
over and over and over to simulate the
model think of like a hurricane simmer
again model of simulation will have all
these projected paths of the hurricane
that's what the Monte Carlo does it
keeps running numbers through and seeing
what's the most likely path for the
capital budget so simulate the
simulation will require you know people
giving the inputs develop low high you
know estimations that correlate with the
coefficients the size in the program and
it's just you know just a very fast
simulation that's going to run through a
huge amount of ranges of variables
determine the correlation coefficients
of some of the most likely outcomes
and you know what's interesting
you could build this model an excel
spreadsheet at first and then when you
have a model down with the variable
inputs that you want to project for the
project you can run it on a more
sophisticated program but that's just
the evolution first you know the idea of
different scenarios developed then more
of a simple simulation and then as a
highly computerized computerized
versions of simulation visit Monte Carlo
alright so let's talk about
international risk considerations so if
you're looking to do put together a
capital budget with projects from across
the world you're going to have to deal
with an exchange rate risk that is
something that's unpredictable very
difficult to know the direction of the
foreign currency but there is you know
standard deviations of the range of the
currency to say that the currency you
know there's a 68 or 95% chance the
currency will not deviate more than this
variance and that would be one of the
inputs in a simulation so a short term
these foreign exchange risks can be
hedged using for foreign currency
futures and option contracts and long
term foreign exchange risk can be
minimized by financing projects in the
in the part of the world that they're
actually going to be generating a
revenues in comes from so that the
currencies spent can be offset of the
currencies generated now a survey of
chief financial officers found that more
than 40% of CFOs felt that it was
important to adjust for our projects for
investment projects cash flow or
discount rates to account for the
foreign exchange risk so a lot of CFO's
more than 40% so a majority of them
would want to adjust the project's cash
flows using discount rates to account
the foreign exchange risk so kind of
build that into the project now other
considerations or a political risk there
could be change of government change of
leadership change of party dispositions
and rules laws and how they view foreign
companies and
access foreign companies have to their
domestic populations and markets so
political risk can be measured some
countries we know of have very low
political risk like Denmark and some
countries can have a very high political
risk like Qatar
alright so different the difficulties of
managing political risk is that you know
a lot of things can be unpredictable but
it can be quantified to a small respect
of you know we know which countries are
riskier in which companies our countries
are less risky so we can adjust the
project's expected cash flows by the
amount of being a political risk or
interference that would be you know
added cost of doing business in those
countries other considerations are taxes
taxes are different in different
countries transfer pricing you know
moving products between countries
another strategic financial
considerations that you know you may
want to start a project in the country
where you know you're not going to have
a huge return just to develop a
relationship with that country and that
would be a strategic move rather than a
financial move for some manufacturers
some companies just you know get the
foot in the door even if you're taking a
loss on it and hope hopefully making
more money later on this brings us to
the risk adjusted discount rates or the
are ADR so one way that we can modify
the net present value is to increase or
decrease the discount rate based on the
risks associated with the project so we
start with the company's discount rate
which is often thought of as the way it
caused the capital and the average way
to cost the capital and we may want to
add a factor to this say you know maybe
the weighted average cost of capital is
7% but we're adding two percent of risk
to the discount rate and that would be
our risk adjusted discount rate and that
will help us to lower the cash flows in
in response to the higher risks so that
would be this modified formula here
a formula we're very familiar with from
chapter ten and eleven
okay so let's just think some personal
finance example here so this person
considered investing a thousand dollars
in either to stock stock a or stock B
and she plans to hold the stock for
exactly five years and expects both docs
to pay eighty dollars in annual
end-of-the-year cash dividends at the
end of the five year she estimates that
stock a can be sold for net value of
twelve hundred and stock B can be sold
for net value of fifteen hundred our
research indicates that she would earn
an annual return on the risk adjusts on
the average risk of the stock of eleven
percent because stock B's consider Li
riskier she's going to require fourteen
percent return from it so she's going to
make the following calculations to make
a risk adjusted present values for the
two stocks so here she is taking the $80
dividends and dividing by one plus
eleven percent of the risk for the
discount rate with risk for project day
and of course the remaining twelve
hundred twelve hundred dollars when she
sells the stock minus the initial
investment gives us seven dollars eighty
one cent net present value on stock B
which is riskier she's dividing each of
the cash flows by one plus the 14% to
the power and then the $1500 outlay at
the end when she sells the stock minus
the $1,000 gives you a fifty three
dollar net present value saying the
stock a is not the best choice stock B
would be a better choice even though
it's riskier because the outcome is
you're selling it's going to be
appreciating more at the end of the five
years how they know what's really a flaw
in this example is there's no way of
really knowing where the stock price is
going to be in five years that they
could easily be you know flip-flops are
greatly different numbers so it's sort
of a flawed example but you get the idea
that even if the risks are higher if the
overall you know gain on the stock price
at the end it may make one investment it
seems riskier actually better investment
okay so we're talking about discount
rates we know that discount rates
are generally for corporate most
corporations are going to be the cost of
their capital and the capital asset
pricing model helps us to define risk
and we know that risk is made up of non
diversifiable and diversifiable risk so
these two risks together and it's just
like the word says non diversifiable
risk means you can't buy other companies
or other you know projects to mitigate
the risks a diversifiable risk you can
reduce this risk by diversifying your
assets so we know that assets traded is
efficient market to the you know assets
traded within an efficient market the
diversifiable risk which is you know the
result from uncontrollable random
effects can be eliminated through
diversification which and the relevant
risk therefore is only the non diversify
risk is the relevant risks we assume
that everybody is able to diversify now
for owners of these assets they want to
make sure you always want to minimize
risk so non diversify risk for
securities are commonly measured easily
measured by beta which is you know the
degree of which an asset moves in
correlation to the market which again we
learned in previous chapters so here's
the capital asset pricing model again as
presented in in multiple chapters of
prior to chapter 12 that we can help use
to measure risk now we can use this
capital asset pricing model help us to
find the our ad RS so let's look at
project we're going to look at project L
and R and we're going to plot them okay
so I'm going to look at project del and
project R and we want to look at
internal rate of return for L and R and
you know a couple things consider
project L generates a returned greater
than the required rate of return
and project L will have a positive net
present value when these cash flows are
discounted at the required return if we
look at project our project our will
have a negative net present value when
its cash inflows are discounted at the
quarry rate of return so our should be
rejected so if we look at this scale
here we have project R and project L so
you see the project our falls below the
security market line so this is sort of
sort of where we want the projects about
to be above this line so the market is
basically this this line here so we have
the market return meets the beta of the
market so as the beta increases the
return needs to increase so for the beta
for L we're actually going to plot the
return is going to be higher than the
SML so this anything below the SML line
is reject which have a net present value
less than zero
anything above the SML line is an accept
our net present value above zero so this
is the graphical representation of
capital asset pricing model and the
security markets risk and we can look at
here we have the risk-free rate and we
have the internal rate of return for
project are the risk of project R so you
see the risk of project R is greater
than the return so obviously reject here
we have the risk for project L is less
than the return for L so that's why it's
an accept and of course in the middle we
have the market return which equals the
beta one okay now when we talk about
capital projects we have to also think
in ethical terms not just profit only
terms so we have a company like British
Petroleum which went around for good
number of years shooting their mouth off
about how great they are how you know
ethical they are how they're investing
in alternative energies and their green
company and they repainted all their gas
stations green and white with energy
symbol to really change their in
bitch but behind the scenes they're
making capital budgeting decisions to
buy risky capital budget decisions in
some of their investments you know for
example they could have bought more
expensive safer equipment for the
Deepwater Horizon drilling operation
which they did it so doesn't have the
most sophisticated they have a bare
minimum on some of their specifications
on that offshore drilling rig and we all
know what happened it eventually
exploded we sank to the bottom of Gulf
of Mexico killing 11 people and
polluting millions of gallons of ocean
water so their stock price took a huge
hit based on this crisis so if the
ultimate goal affirm is to maximize
wealth then you know if you do it in the
short run it may actually be positive
for the short run but affect your
overall long term maximizing a Cheryl as
well if your ethical unethical decisions
or come back to make the company look
bad so this is something to consider
when you're making decisions of the
corporate level that yeah you could you
could do something that is right now
going to save money but long term could
be a problem sort of like think about
the ethics of Flint Michigan the
municipality decided to save money by
taking the drinking water out of a river
that was highly polluted and highly
toxic I'd from so many companies dumping
waste in it for so many years rather
than a much cleaner water sauce from one
of the Great Lakes and you could see how
that decision yeah and save money
however it's sickened a lot of children
with lead poisoning and a lot of
families were sickened by the the
toxicity of the water which led to the
firing and indictment an arrest for many
municipal officials so who really who
really saved on that the people of the
town Flint Michigan are now going to
have to spend them the state government
the federal government have to spend far
more money to clean up the situation
than if they had just left the water
source
or cleaner water source intact so ethics
do matter it's not just about saving
money and improving profits okay so
let's talk about our ADRs risk discount
rates now the risk adjusted discount
rates is applying the our ADRs so so we
understand how to quantify randall on
risk and measuring for some
uncertainties now we're looking at
project a and B in addition to the data
presented earlier that we talked about
this when we first opened up the
managers assigned a risk index of 1.6
and for project day and 1.0 for project
B at which we're going to show you in
the following table so the required
rates to return associated with these
indexes are then applied to the discount
rates to do proud to determine the net
present value so what we have here is a
scale where we have a risk index from
zero to two so project a lives here and
if a project has the risk index of 1.6
then the adjusted the our ADR is going
to have to be a 14% project B which is
less risky and a risk index of 1 will
have required radio turn of 11% so you
see how this works the less risky the
project on the risk index scale the
lower the required return or the our ADR
that we'd use in determining the capital
budget so if a company some project has
no risk then the return only has to
really match the risk-free rate okay so
a project a is riskier than project B
it's expressed as it's our ADR is 14%
which is greater than 11% so when
calculate the net present value of these
two projects we could see we could do
this in Excel this will be part of our
Excel project for the chapter we can
calculate the cash flow of project a and
this cash Pachuca a has an even stream
of cash flows which we discussed earlier
$14,000 we take away our so the present
value of that is 48,000 at the 14% our
ad D
they are subtract the initial vests we
get net present value of 6,000 here are
the formulas here of how this is
calculated project B we have to
calculate each cashflow separately
because they're not even even stream
like project a so we find the present
value of the cash flows from year one to
five subtract the initial investment
find the net present value using the RA
da R and we get 9,000 so in this case
the net present value of project B is
higher than a we should choose project B
okay and we have a little if statement
here to automatically select project B
which you'll see in the homework for
this chapter if we put this on a time
scale we can see here's project a when
we discount all the cash flows are 14%
and here if we discount each cashflow
individually at 11% which we have to do
individually because this is sort of a
you know present value of annuity
formula this is multiple single value
formulas because we can't put them on
because they're different cash amounts
we have to do them each individually
alright now when talk about portfolio
let's talk about portfolio for a minute
and discount rates now an individual
investor has to hold the diversified
portfolio because they want to minimize
risks they're not rewarded for assuming
diversifiable risk so that's for
individual investors but business firms
can be viewed as you know business firms
can be viewed as a portfolio of assets
and it would it would seem that it is
also important that they should hold
diversified portfolios as well however
that's not really what investors want
investors are diversifying themselves so
they don't need the firm to diversify
for them so we can as an investor we can
diversify by abiding five or six
different companies up to 20 different
companies but we are fine with the
company being less diversified and being
more specialized because diversification
isn't necessarily rewarded and the
corporate level
just think of it this way if McDonald's
diversified into running schools and
into making cars and into making cell
phones and into a a number of different
types of businesses and diversify their
sources of income that's not highly
rewarded in fact even at one point
McDonald's was trying to diversify into
different food restaurants they bought
Boston Market they were had investment
since report lane that has investments
in the pizza chain and they eventually
sold those investments to focus
concentrate on the McDonald's brand so
we don't want these companies are
they're not reward for diversifying
because investors can diversify
themselves so therefore companies should
focus on what they do do well not try to
diversify their risk but concentrate in
the area where they can make the most
money and that's why in a capital
budgeting you're not really trying to
diversify your company's businesses
because it's proven through empirical
evidence that's really not when vesser's
want and it's not what investors makes
not what makes companies successful okay
so we can have risk classes there's
nothing we could do to help determine
the ra.d ours is to decide on different
risk classes to analyze projects so we
can have risk classes say from risk
class one through four so one being
below average risk and four being the
highest risk and then we could make an
adjusted discount rate based on these
risk categories so it's just another way
of trying to formalize the process of
how we're going to adjust the discount
rates based on risk so we can use this
risk classification schedule as an
example so if they if a financial
manager has you know project day was in
class three and project B was in risk
class two then we would have be using an
RD are 14 per day and an RDA of 10 for B
so project day at 14 was calculated in
the previous figure at 6,000 and the net
present value for prod
be a 10% would be let's see this was
actually 11% and previously but so a 10%
it's actually higher at 10,000 so again
even using this risk classifications be
project being preferred over project a
now what if projects have unequal lives
not all capital budgeting projects are
going to be a standard ten or five years
they may have unequal lives or lengths
of projects how do we compare projects
that have different lengths well here's
an example of two projects X&Y
one is only for three years and project
y is for six years how can we make them
comparable well we can we'll see the
cost of capital here is ten percent so
if we actually did the net present value
of both projects separately we get
eleven thousand nineteen thousand would
be is that present value for both
projects now but that's not really
comparable because this is nineteen
thousand over six years and this is
eleven thousand over three years so
which is better so if we ignore these
the lives of the projects that makes it
easy if we don't really care about the
length of the project then we would
choose project Y over X it has a higher
net present value you know however if we
want to use an annualized net present
value approach which was going to help
us to evaluate the unequal unequal lives
of two projects we can we can do we can
do it in three steps so step one
calculate the net present value of each
project over its life using the
appropriate cost of capital to convert
the next present value into an annuity
having a life and end life and that is
find the annuity that has the same life
and the same net present value as a
project and it's like a project based on
the higher higher one so let's just go
through these two projects and it's
using the way I said that so let's kind
of go through the example so the company
company data presented earlier from X&Y
which you remember let's go back here
this is x and y and we have the net
present value at 11 and 19 so it's where
I get these numbers from X net present
value of X net present value of 1 so
step one we've done we've done many
times calculating net present value
based on the inputs for x and y now step
two we're going to do in step two is
we're going to convert the net present
values and from step 1 into annuities so
for project X we're trying to find the
answer to the question of what is what
3-year annuity which is equal to life of
project X has the present value of 11
million our 11,000 the net present value
the project X likewise we do the same
for project Y in step two so if we use
this formula here the a NPV we which
basically we'll see what we how we do
this is we use the payment function in
Excel to calculate the payment of the
annuity for Project X and project Y we
see the project X has a higher annual
payment than Project Y and that would
lead us to choose project x over
projects y annualizing the present value
and again it's very simple to do this we
would use the payment function to
calculate the cash flow of the annuity
and the Excel spreadsheet again we'll be
doing this in the end of chapter problem
work okay so step 3 reviewing the a
NTV's we see that project x would be
preferred now over project way because
Project X has a better more higher
annualized net present value than
project Y and assuming these are most
mutually exclusively I can only pick one
we would now would be picking Y for
project X over Y okay so let's talk
about real options
now trying to bring some real business
on this chapter is really about trying
to bring some more real world issues and
risks into the capital budgeting process
because chapter 10 and 11 the capital
budgeting process was a little more
sterile in this chapter 12 we're trying
to talk about risk in more real-world
scenarios the projects have different
risks projects have different timeframes
and we have to make adjustments for that
now real options look at opportunities
that could be embedded inside of
projects that we should also consider or
also utilize to adjust the risk you know
so recognizing the options when making
and capital budgeting decisions managers
can more can better improve their future
returns or their strategic decisions
considering in advance the economic
impact of certain actions taken by the
project so we have the traditional net
present value that we know how to
calculate and we can answer that the
value of a real option and that would
give us our what we call a strategic net
present value so let's talk about what
are the real options what are the you
know so think about company think
different opportunities companies have
when they take on certain projects so
certain projects are getting the foot in
the door projects so if I take on this
project say with a school district this
small project of doing this one type of
service then they get to know me as
vendor they gets my foot in the door and
then I could should should be able to
more easily sell or work with them on
bigger projects you know say you know if
you are a local landscaper you may give
a discount on the fall cleanup they a
very attractive full cleanup price in
hopes that you'll gain a more lucrative
summer contract of weekly landscaping
you know so some of the major types of
real options that the chapter talks
there is abandonment option so the
option to abandon to terminate the
project prior to the end of its life
being that you can end the project early
so if there's a problem with the project
you can minimize the damage and get out
of it more easily so if you're taking on
a project where you have some guarantees
or some reassurances that you could end
the project without being financially
hurt early that is something that should
be considered when making the capital
budget decision flexible options you
know if do you have the flexibility
within the capital budgeting decision to
do other things to maybe generate some
additional income so maybe it's some
sort of flexible factory that if you
you're able to reconfigure the factory
to produce to make other projects so
maybe your car manufacturer and you're
building a new manufacturing plant to
make cars most manufacturing plants to
make cars are not flexible they're made
to make one type of car either sedan a
truck particular economy class car but
if you were to invest a little bit more
money in the factory you can make it a
flexible factory so if you looked at a
inflexible versus a flexible factory the
inflexible factory would have higher net
present values because the flexible
factory would be more expensive initial
investment to make but the flexible
factory can allow you to switch over
from sedans to trucks or trucks to
luxury or luxury the economy class
vehicles very easily there is additional
value in that that should be added to
the cash flows when deciding whether or
not to make this decision because you're
recognizing that there's an embedded
advantage to taking the flexible factory
growth options so if a particular
project helps you to expand the market
for example we're going to invest in a
store location maybe we're Walmart and
we want to invest in the store location
in Spain this is sort of our we know
that this initial location will lose
money because we have to advertise for
one store we have to build a network as
an infrastructure for one store so this
first store is going to lose money so
the net present value of it of opening
up another store in the United States
versus the noose
or in Spain would be we should net
present value would say open up this new
store United States but the growth
options is if this one store works in
Spain we can open up a hundred other
stores in Spain more easily and it won't
be more able to expand growth in the
area so if there's an added benefit of
additional future growth that should be
recognized as a real option and then
also timing option the so this option
recognizes the firm's opportunity to
delay the acceptance of a project for
one or more periods so to accelerate the
process or slow down the process based
on new information or shut down the
product the project temporarily without
you know extreme cost so timing options
having the ability to time your
investment is also another real option
so these real options are just things to
think of beyond the numbers of the
capital budgeting beyond the risks that
we can then we can we can put into it
we're thinking beyond the project in the
bigger picture so real options connect
the company more to the bigger project
picture of why we're doing this you know
so all right so how do we recognize
these real options in our project so
assuming that a strategic analysis of
again that's been a company project day
in project B we find no real options
embedded in project a but two real
options better than project B so project
B during the first two years we would
have a downtime that we could use the
production facility to do contract
manufacturing meaning that you know we
could use some of the facility actually
make products for somebody else and
they'll pay us for it and B the
computerized control system that
controls the two machines for project B
we're able to utilize a control system
for other machines reducing our labor
cost so project B has these sort of
special benefits in it compared to
project day so how we could do this is
we have to estimate the net present
value of the contract manufacturing over
the next two years following implant
project beam so we know that there will
be $1,500 and the net present value of
the computer control system would be two
thousand so 1500 is the value of the
contract packaging two thousand of the
computer control system so the
management feels that there's a 60%
chance that the contract manufacturing
option would be exercised and a 30%
chance that computer control system
option will be actually exercised so the
combined value of these two real options
we could lay out in this mathematical
formula so we could say 60% x 1500 plus
30% of 2000 would give us a real option
of 1500 okay all right so now if we add
the $1500 a real option to the value of
the traditional net present value we're
going to elevate that to twelve thousand
four hundred and twenty four for project
B now if we look at a project B has a
strategic net present value of twelve
thousand four hundred which is well
above a traditional in their present
value and exceeds project AIDS net
present value of eleven thousand so now
project B is more acceptable than
project a so recognizing and quantifying
projects real options helps to improve
our decision-making abilities within
capital budgeting okay now capital
rationing this is an understanding that
companies have limited amounts of funds
so they have to ration their capital
based on the independent product
projects available and the capital they
have available to invest in those
projects so most companies have more
projects than the money and the ability
to invest in them so in theory capital
rationing should not exist because firms
should be able to accept all the
projects that have net positive net
present values however in practice firms
are under our capital rationing there's
a limited amount of money and also
manpower to take on all these projects
so generally a firm tries to isolate
select the best projects
to invest their money in to a to utilize
their you know to raise funds and
utilize their capital budget as best as
possible so we can do the internal rate
of return approach where we ration our
projects by graphing the internal rate
of return in descending order against
the total dollar amount invested to
determine a group of acceptable projects
now the graph was going to show in a
minute that plots the projects on the
internal rate of return in descending
order against the dollars invested is
called the investment opportunity
scheduled at iOS so the problem is that
this technique does not guarantee the
maximum dollar return for the firm
although it's easily understood this is
the chart right here it's easily
comprehended so here's project B C and E
and our budget constraint is - we can't
go over 250,000 so we'd have to stop at
accepting just these three projects and
project a F and D we'd have to let go
because we don't have enough money for
them so if we look at these the cost
assuming cost the capital of 10% the six
projects were competing for have you
know we have one two three four five six
projects here's the internal rate of
return they say all of them but one
project is above ten percent so we could
we could theoretically we had enough
money we can accept five of these six
projects but we have a fixed budget of
250,000 which is the best selection of
projects to make to maximize the
company's profits so we talked about the
i/os schedule but with but generally
it's not the best methodology for
improving the companies well you know
now if we so if we look at this schedule
and project BCE BCE if we accept the B C
and E based on that's iOS scale together
to absorb $230,000 of the budget
projects 8 AF project and F are
acceptable but cannot be chosen because
other budgeting constraint project D is
not worthy because it's only 8% return
we need 10 or better so the net present
value approach a capital rationing is
based on using the present values to
determine the the best group of projects
that maximize the shareholders wealth so
implementing the ranking projects basis
a basis of internal rate of return then
evaluating the net present value
benefits for each of the potential
projects we determine the best
combination of projects with the overall
highest present value so here if we look
at these projects we see that here's the
initial investment the internal rate of
return and then we also have the present
value of the cash flows so all these
five are accessible only project E is
not acceptable so if if we look at
project B C and E together they yield a
present value of three hundred and
thirty six thousand dollars however
projects B C and a if they were
implemented the budget would be up to
250 thousand so we could do BCA so this
would be B C and a so seventy plus one
hundred one hundred seventy thousand
plus eighty gives us our 250 thousand
dollars that they're talking about here
so the present value of those cash flows
would be greater at three hundred fifty
seven thousand so implementing B C and a
would be preferable because it maximizes
the present value of the cash flows for
the given budget now the firm's
objective is to use the budget generate
the highest present values in flows the
caster's cash possible that's really the
objective now so we're doing this
capital rationing we wouldn't the
internal rate of return iOS schedule
would not have us choose BCA but if we
look at it this way we can figure out
that you know what BCA is a better
grouping of projects to get the return
that we need okay so those are some of
the main I've covered all the main
learning goals of chapter 12 and
discussed capital rationing scenario
analysis simulations Monte Carlo adjust
the discount rates for
risk and for time and this gives us an
also real option so this gives a better
more real-world perspective on capital
budgeting and some of the more nuanced
factors influencing a manager's decision
of how to put a capital budget together
to optimize their present value of the
cash flows based on the projects that
they can accept okay thank you very much
for listening to this entire lecture
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