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Click to edit Master style,Click to edit Master text styles,Second Level,Third Level,Fourth Level,Fifth Level,14-,*,Chapter 14,Risk and Managerial Options in Capital Budgeting, 2001,Prentice-Hall, Inc.,Fundamentals of Financial Management, 11/e,Created by: Gregory A. Kuhlemeyer, Ph.D.,Carroll College, Waukesha, WI,Risk and Managerial Options in Capital Budgeting,The Problem of Project Risk,Total Project Risk,Contribution to Total Firm Risk: Firm-Portfolio Approach,Managerial Options,An Illustration of Total Risk (Discrete Distribution),ANNUAL CASH FLOWS: YEAR 1,PROPOSAL A,State,Probability,Cash Flow,Deep Recession,.05,$ -3,000,Mild Recession,.25,1,000,Normal,.40,5,000,Minor Boom,.25,9,000,Major Boom,.05,13,000,Probability Distribution of Year 1 Cash Flows,.40,.05,.25,Probability,-3,000 1,000 5,000 9,000 13,000,Cash Flow ($),Proposal A,CF,1,P,1,(,CF,1,)(,P,1,),$ -3,000,.05,$ -150,1,000,.25,250,5,000,.40,2,000,9,000,.25,2,250,13,000,.05,650,S,=,1.00,CF,1,=,$5,000,Expected Value of Year 1 Cash Flows (,Proposal A,),(,CF,1,)(,P,1,),(,CF,1,-,CF,1,),2,(,P,1,),$ -150,(,-3,000,-,5,000,),2,(,.05,),250,(,1,000,-,5,000,),2,(,.25,),2,000,(,5,000,-,5,000,),2,(,.40,),2,250,(,9,000,-,5,000,),2,(,.25,),650,(,13,000,-,5,000,),2,(,.05,),$5,000,Variance of Year 1 Cash Flows (,Proposal A,),Variance of Year 1 Cash Flows (,Proposal A,),(,CF,1,)(,P,1,),(,CF,1,-,CF,1,),2,*(,P,1,),$ -150,3,200,000,250,4,000,000,2,000,0,2,250,4,000,000,650,3,200,000,$5,000,14,400,000,Summary of,Proposal A,The,standard deviation,= SQRT (14,400,000) =,$3,795,The,expected cash flow,=,$5,000,An Illustration of Total Risk (Discrete Distribution),ANNUAL CASH FLOWS: YEAR 1,PROPOSAL B,State,Probability,Cash Flow,Deep Recession,.05,$ -1,000,Mild Recession,.25,2,000,Normal,.40,5,000,Minor Boom,.25,8,000,Major Boom,.05,11,000,Probability Distribution of Year 1 Cash Flows,.40,.05,.25,Probability,-3,000 1,000 5,000 9,000 13,000,Cash Flow ($),Proposal B,Expected Value of Year 1 Cash Flows (,Proposal B,),CF,1,P,1,(,CF,1,)(,P,1,),$ -1,000,.05,$ -50,2,000,.25,500,5,000,.40,2,000,8,000,.25,2,000,11,000,.05,550,S,=,1.00,CF,1,=,$5,000,(,CF,1,)(,P,1,),(,CF,1,-,CF,1,),2,(,P,1,),$ -50,(,-1,000,-,5,000,),2,(,.05,),500,(,2,000,-,5,000,),2,(,.25,),2,000,(,5,000,-,5,000,),2,(,.40,),2,000,(,8,000,-,5,000,),2,(,.25,),550,(,11,000,-,5,000,),2,(,.05,),$5,000,Variance of Year 1 Cash Flows (,Proposal B,),Variance of Year 1 Cash Flows (,Proposal B,),(,CF,1,)(,P,1,),(,CF,1,-,CF,1,),2,(,P,1,),$ -50,1,800,000,500,2,250,000,2,000,0,2,000,2,250,000,550,1,800,000,$5,000,8,100,000,Summary of,Proposal B,The standard deviation of,Proposal B,Proposal A,.(,$2,846,-($266.67),What is the,“new”,project value?,Project Abandonment,$ 2,238.32,$ 1,331.29,$ 1,059.18,$ 344.90,$ 72.79,-$ 199.32,-$ 1,280.95,-$900,(,.20,),$1,200,(,.20,),-$400*,(,.,60,),$450,Year 1,1,2,3,(,.60,),$1,200,(,.30,),$ 900,(,.10,),$2,200,(,.35,),$ 900,(,.40,),$ 600,(,.25,),$ 300,(,1.0,),$ 0,Year 2,*-$600 + $200,abandonment,Summary of the Addition of the Abandonment Option,*,For “True” Project considering abandonment option,The,standard deviation*,= SQRT (740,326) =,$857.56,The,expected,NPV*,=,$,71.88,NPV*,= Original NPV +,Abandonment Option,Thus,$71.88,= -$17.01 +,Option,Abandonment Option,=,$ 88.89,
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