Question

1.A) What are the three types of risk that are relevant to capital budgeting? How is each of these risks measured, and how do they relate to one another? How is each type of risk used in the capital budgeting system?

B) Are there problems with scenario analysis? Define Simulation analysis, and discuss its principal advantages and disadvantages.

C) What is a real option? What are some types of real options?

Answer 1

A. Three types of risk in capital budgeting are

i)Stand alone risk

ii)Corporate risk

iii)Market risk

i)Stand alone risk:The project risk it it were the firm's only assets and there were no shareholders.Ignores both Firm and shareholders diversification.

Measure by the alpha or CV of NPV or IRR.

Stand alone risk is easiest to measure and the most intuitive.Core projects are highly correlated with other assets,so stand alone risk generally reflects corporate risk.If the project is highly correlated with the economy stand alone risk also reflects market risk.

ii)Corporate risk :It reflects the project's effort on corporate earnings stability.Considers firm's other assets.Depends on the project's alpha,and it correlations,beta with returns on firm other assets.Measure by the projects corporate beta.

Creditors customers,suppliers and employee are more affected by corporate risk.

iii) Market risk:It reflects the projects sffect on a well diversified stock portfolio.Takes account of stockholder's other assets.Depends on projects alpha and correlation with the stock market.

Measured by the Project's beta.Market risk is theoretically best in most situations.

B) Problems with scenario analysis

i)Success of Scenario analysis is unpredictable :We might do a proper detailed scenario analysis,get facts,make clear assumptions about all the possible scenarios,but we can never know if the scenario will play out exactly as we expect it to.

ii)Cognitive Bias: There are the times when decision makers take multiple scenarios- say best,average & worst.This is a dangerous situations because as human nature we consider that occurence of average scenario is the most likely.Thus we are biased to make decisions based on average scenario.The huaman brain is wired in a certain way & its perceptions affect all decision making.

iii)Require Continous improvements:Scenarios require continuos revision,refinement & control by an expert or a specialised team.One must periodically updates the scenario analysis & make decision to get maximum benefit out of scenario analysis.

Simulation Analysis:It is a method,wherein the infinite calculations are made to obtain the possible outcomes and probabilities for any choice of action.

Main Advantages of Simulation analysis include:

i)Study the behaviour of system without building it;

ii)Results are accurate in general,compared to analytical model;

iii)Help to find unexpected phenomenon,behaviour of the system;

iv)"What if" questions can be answered.

Main Dis-advantages of Simulation analysis include:

i)Model building requires special training;

ii)Simulation results can be difficult to interpret;

iii)Simulation modeling and analysis can be time consuming and expensive.

C)Real option: A real option is a choice made available to the managers of a company concerning business investment oppurtunities.It is referred to as real because it typically references projects involving a tangible assets instead of a financial instruments.Real options are a right but not an obligations to make a business decision.

Types of real options are

i)Option to expand:It is the option to make an investment or undertake a project in the future to expand the business operations.

ii)Option to abandon:it is the option to cease a project or an assets to realise its salvage value.

iii)Option to wait:It is option of deferring the business decision to the future.

iv)Option to Contract:It is the option to shut down a project at some point in future if conditions are unfavourable.

v)Option to switch:It is the option to shut down a project at some point in future if conditions are unfavourable and resume it when the conditions are favourable.