Uncertainty in Capital Budgeting, Debt, and Equity

admin — Sat, 23 May 2009 10:43:44 +0000

We now turn to the problem of selecting projects under uncertainty. Your task is to compute present values with imperfect knowledge about future outcomes. Your principal tool in this task will be the payoﬀ table (or state table), which assigns probabilities to the project value in each possible future value-relevant scenario. For example, a ﬂoppy disk factory may depend on computer sales (say, low, medium, or high), whether ﬂoppy disks have become obsolete (yes or no), whether the economy is in a recession or expansion, and how much the oil price (the major cost factor) will be. Creating the appropriate state table is the manager’s task— judging how the business will perform depending on the state of these most relevant variables. Clearly, it is not an easy task even to think of what the key variables are, to determine the probabilities under which these variables will take on one or another value. Assessing how your own project will respond to them is an even harder task—but it is an inevitable one. If you want to understand the value of your project, you must understand what the project’s key value drivers are and how the project will respond to these value drivers. Fortunately, for many projects, it is usually not necessary to describe possible outcomes in the most minute detail— just a dozen or so scenarios may be able to cover the most important information. Moreover, these state tables will also allow you to explain what a loan (also called debt or leverage) and levered ownership (also called levered equity ) are, and how they diﬀer.

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Uncertainty in Capital Budgeting, Debt, and Equity