Risk Analysis and Real Options in Capital Investment Flashcards
What is Risk analysis?
Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment
Risk cannot be ignored entirely, but mathematical approaches can be impossible because of lack of critical information
The following approaches are frequently used to asses risk:
- Informal method
- Risk-adjusted discount rates
- Certainty equivalent adjustments
- Simulation analysis
- Sensitivity analysis
- Monte Carlo technique
What is the Informal method?
Approach used to assess risk
Informal method - NPVs are calculated at the firm’s desired rate of return and the possible projects are individually reviewed. If the NPVs are relatively close for two mutually exclusive projects, the apparently less risky project is chosen
What is the Risk-adjusted discount rates technique?
Approach used to assess risk
Risk-adjusted discount rates - this technique adjusts the rate of return upward as the investment becomes riskier. By increasing the discount rate from 10% to 15%, for example, the expected flow from the investment must be relatively larger or the increased discount rate will generate a negative NPV and the proposed acquisition/investment would be rejected
Although difficult to apply in extreme cases, this technique has much intuitive value
What is the Certainty equivalent adjustments technique?
Approach used to assess risk
Certainty equivalent adjustments - this technique is directly drawn from the concept of utility theory. If forces the decision maker to specify at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risk sum
The technique is not frequently used because decision makers are not familiar with the concept
What is Simulation analysis?
Approach used to assess risk
Simulation analysis - this method represents a refinement of standard profitability theory. The computer is used to generate many examples of results based upon various assumptions.
Project simulation is frequently expense. Unless a project is exceptionally large and expensive, full-scale simulation is usually not worthwhile
What is Sensitivity analysis?
Approach used to assess risk
Sensitivity analysis - forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions
Changing or relaxing the assumptions about a certain variable of group of variables may drastically alter the NPV. Thus, the asset may appear to be much risker than was originally predicted
In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions
What is the Monte Carlo technique?
Approach used to assess risk
The Monte Carlo technique is often used in simulation to generate the individual values for a random variable
The performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each of the variables in the model (based on the probability distribution of each variable) and then calculating the value of the solution. If this process is performed a large number of times, the distribution of results from the model will be obtained
Example: Suppose a new marketing model includes a factor for a competitor’s introduction of a similar product within 1 year. Management estimates there is a 50% chance that this will happen
For each simulation, this factor must be determined, perhaps by flipping a coin or by putting two numbers in a hat and selecting one number. Random numbers between 0 and 1 could be generated. Numbers under one-half reveal a similar product; numbers over one-half reveal no similar product
How can CAPM be used to assess risk?
Approach used to assess risk
Capital asset pricing model (CAPM) - this method is derived from the use of portfolio theory. It assumes that all assets are held in a portfolio. Each asset has variability in its returns. Some of this variability is caused by movements in the market as a whole and some specific to each firm
In a portfolio, each security’s specific variability is eliminated through diversification and the only relevant risk is the market component
The more sensitive an asset’s rate of return is to changes in the market’s rate of return, the riskier the asset
What are Real (managerial or strategic) options?
Real (managerial or strategic) options reduce the risk of an investment project. A real option is the flexibility to affect the amounts and risk of an investment project’s cash flows to determine its duration or to postpone its implementation
A real option is ordinarily par of a major (strategic) project and involves real (not financial) assets
Real options may be viewed as call options or put options (i.e. an abandonment option is in essence a put option and a wait-and-learn option is in essence a call option)
What is the value of a real option?
The value of a real option is the difference between the project’s NPV with out the option and its NPV with the option
Similarly, the worth of the project (true NPV) equals its NPV without the option + the value of the option
What are some attributes of real options?
The greater the availability of real options and the uncertainty related to their exercise, the greater the worth of the project. The reason is that increased uncertainty (greater variability of potential cash flows) enhances the likelihood that an option will be exercised and therefore increases its value
Real options are not measurable with the same accuracy of financial options because the formulas applicable to financial options may not be appropriate for real options
Thus, other methods (i.e. decision tree analysis with recognition of probabilities and outcomes and simulations) are used in conjunction with discounted cash flow methods
What is the Replicating portfolio method?
An approach that exploits the availability of derivatives and other securities that are sensitive to specific risks is the replicating portfolio
This method involves identifying securities trading in efficient public markets with cash flows that are the same as those of the real option. Accordingly, these securities must have cash flows and fair values that respond to the same risks as the real option
Given the known prices of the securities, the firm may calculate the value of the portfolio and presumably, the real option with the same cash flows
Advantage - this method does not require estimating a discount rate for a discounted cash flow analysis
Disadvantage - the need to estimate the effects on cash flows of multiple sources of risk
What are the various types of real options that are available to management accountants?
Management accountants should be able to determine what real options are embedded in a project to measure their value and to offer advice about structuring a project to include such options. The following are among the types of real options:
- Abandonment option
- Follow-up investment option
- Wait and learn option
- Flexibility option
- Capacity option
- New geographical market option
- New product option
What is an Abandonment option?
Type of real option
Abandonment of a project entails selling its assets or employing them in an alternative project. Thus, the abandonment value of a project may be approximated. Abandonment should occur when (as a result of ongoing evaluation process) the entity determines that the abandonment value of a new or existing project exceeds the NPV of the project’s future cash flows
The abandonment option enhances a project’s worth by allowing the entity to profit from favorable conditions while allowing it to reduce its risk when conditions are unfavorable
Thus, a project should be designed so that it has multiple decision points and total commitment of resources to project completion is deferred
Note: An abandonment option is in essence a put option
What is a Follow-up investment option?
Type of real option
The option of making a follow-up investment (expansion) may be the factor that renders a project feasible. NPV for the initial project may be negative because its scale is inefficient
For example, a new factory may lack the capacity to be profitable even if it can sell all of its output. However, if demand is expected to increase, a subsequent investment to expand capacity to an efficient scale may be profitable
The follow-up option is based on the assumption that the expansion would not have been possible without the first-stage investment
