Risk Analysis, Real Options, and Capital Budgeting
Risk Analysis, Real Options, and Capital Budgeting
This chapter discusses a number of practical applications of capital budgeting.
Though NPV is the best capital budgeting approach conceptually, it has been criticized in practice for providing managers with a false sense of security. Sensitivity analysis shows NPV under varying assumptions, giving managers a better feel for the project's risks. Unfortunately, sensitivity analysis modifies only one variable at a time, while many variables are likely to vary together in the real world. Scenario analysis examines a project's performance under different scenarios (e.g., war breaking out or oil prices skyrocketing). Finally, managers want to know how bad forecasts must be before a project loses money. Break-even analysis calculates the sales figure at which the project breaks even. Though break-even analysis is frequently performed on an accounting profit basis, we suggest that a net present value basis is more appropriate.
Monte Carlo simulation begins with a model of the firm's cash flows, based on both the interactions between different variables and the movement of each individual variable over time. Random sampling generates a distribution of these cash flows for each period, leading to a net present value calculation.
We analyze the hidden options in capital budgeting, such as the option to expand, the option to abandon, and timing options.
