Cash Flow at Risk (CFaR) can be controlled using real options. In this normative paper, we derive numerically a univariate discrete time model, extension of (Kulatilaka, 1988), the expanded Net Present Value (NPV) of an industrial investment and simultaneously state variable thresholds to optimally exercise real options for the whole life of the project. In this framework, we model total variability in expanded NPV using a Markov chain Monte Carlo method. A number of original results are derived for an all equity financed firm. Cash flow distribution and CFaR is used for each epoch in the life of the project. A VaR for the expanded NPV at time 0 is derived. These new methods have been applied to two case studies in shipping finance, namely a Very Large Crude Carrier and a Panamax.
The control and reduction of volatility of profits from operations is beneficial to
shareholders’ wealth which should seek it through appropriate hedging operations. This
has been well proven both from a theoretical and an empirical point of view.In a firm viewed as a nexus of exposures (MacMinn, 2002), Enterprise Risk
Management (ERM) can be implemented in a transaction by transaction way or in a
holistic integrated way, hedging overall profitability of the firm against marketable risks.
In both these approaches to ERM, the role of real options is neglected, overlooking the “in house” hedging effect of managing an industrial plant according to real options.
Capital budgeting for intrinsically illiquid assets like industrial plants is interwined
with risk management. Hence there is the need to value investment projects not only
within the usual risk return framework but also taking into account their diversifiable risk
dimensions (Stultz, 1999).
In this paper, we add a new dimension to capital budgeting with real options: In a
univariate framework, (Kulatilaka, 1988), we model total variability in expanded NPV and
in CF in each period of the investment project life when this is managed exercising
optimally real options. This allows us to tackle downside risk from two different
perspectives. From a static point of view, we provide a measure of what is usually called
the “project at risk” or a VaR of expanded NPV. From a dynamic point of view, instead,
we provide a measure of the downside risk in each epoch of the investment both from a
timeless and a path dependent perspective. This, in turn, ends up in modeling the survival
probabilities of the investment project. |
