Exam 22: Real Options

In real options, the required investment is considered the exercise price.

In terms of real options, the cash flows from the project play the same role as

In an acquisition, the target firm may demand compensation from the acquiring firm if the deal falls through. The acquiring firm's compensation is for the payment of a form of a real call option.

Contrast the difference between the NPV of an investment and the value of the option to invest in it. I.The value of the option to invest increases with interest rates while the NPV decreases. II.The value of the option to invest decreases with an increase in short-term cash flows while NPV increases. III.The value of the option to invest and the NPV of the project are unrelated.

You are considering making a "Hillary" action figure to capitalize on popular political fever. Production will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present value [PV]). If voters do not catch the political fever, you will only sell action figures worth $2 million (in PV)as only loyal Democrats will buy. Each possibility has a 50 percent chance. However, before production begins, you can conduct a marketing survey to determine which scenario will happen. The survey costs $1 million. Is it worth conducting the survey? Why?

Which of the following scenarios fails to describe a possible real option embedded in a project analysis?

The following are examples of expansion options: I.A mining company acquires mineral rights to land that is not worth developing today but could be profitable if ore prices increase. II.A film studio acquires the rights to produce a film based on the novel. III.A real estate developer acquires a parcel of land that could be turned into a shopping mall. IV.A pharmaceutical company purchases a patent to market a new drug.

Managers who hold real options should view

Explain the main difference between the Black-Scholes formula and the binomial method. How does this relate to real options analysis?

If an oil well allows the investor the option to drill later, what must happen for the option to be exercised?

Which of the following are examples of real options? I.the option to expand if an investment project succeeds; II.the option to wait (and learn)before investing; III.the option to shrink or abandon a project; IV.the option to vary the mix of output or the firm's production methods

Assume the following data for Project X: NPV of the project without abandonment: −$2 million; abandonment option value: $4 million. Calculate the adjusted present value (APV)of the project.

Temporary abandonment is a very simple call option that allows the firm to stop a project temporarily until conditions improve.

How does an abandonment option increase the value of a project?

Production facilities that are flexible, in terms of the potential to use different combinations of raw material inputs, are most valuable when

The risk-neutral approach is an application of the certainty equivalent method.

A rational manager may be reluctant to commit to a positive net present value project when

Which of the following conditions might lead a financial manager to decide to expedite a positive net present value investment project?

The owner of a pro-football team expects the team to be worth either $270 million next year or $120 million, depending on whether or not she gets the city to build a new stadium. There is a 60 percent chance she will get a new stadium. There is a buyer willing to pay $180 million for the team right now. However, the buyer will keep his offer open-until the stadium issue is resolved-if offered some form of compensation. If the interest rate is 6 percent, how much should she be willing to pay the potential buyer for a one-year option to sell the team (round to the nearest $1 million)?

The following are practical challenges in applying real-options analysis: I.Real options can be complex. II.The real options problems may not be well structured. III.Competition may reduce or change the value of real options.