Exam 22: Real Options

A firm has a two-year real option to invest in a project that has a present value of $400 million with an exercise price (in year 2)of $600 million. Calculate the value of the option given that N(d1)= 0.6 and N(d2)= 0.4. Assume that the risk-free interest rate is 6 percent per year.

Briefly explain how temporary abandonment can be thought of as a complex option.

An abandonment option, in effect,

A firm has a three-year real option to invest in a project that has a present value of $500 million with an exercise price (in year 3)of $800 million. Calculate the value of the option given that N(d1)= 0.3 and N(d2)= 0.15. Assume that the risk-free interest rate is 6 percent per year.

The first step in a real options analysis is to value the underlying asset using the discounted cash-flow (DCF)method.

The binomial method can be used for most abandonment options.

Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions is co-firing equipment least valuable? Let a_c be the annual standard deviation of coal prices, and let a_n be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices.

Real options cannot be valued using the risk-neutral method since real assets do not trade in a liquid market where prices are readily observable and arbitrage opportunities are exploited immediately.

Which of the following are examples of applications of real options analysis? I.a strategic investment in the computer business; II.the valuation of an aircraft purchase option; III.the option to develop commercial real estate; IV.the decision to mothball an oil tanker

The option to wait is a type of real option.

Briefly explain the implied assumption when the risk-neutral method is used for valuing real options.

Which of the following statements about the option to build flexibility into production facilities is true?

Briefly discuss three practical problems associated with real options analysis.

Adjusted present value of project (APV)= NPV (without abandonment option)+ value of abandonment option.

How can managers take advantage of real options? Briefly explain.

The option to expand is a type of financial option.

The opportunity to defer investing to a later date may have value because I.the cost of capital may increase in the near future; II.uncertainty may be increased in the future; III.the project has positive, short-term cash flows; IV.market conditions may change and increase the NPV of the project

Which of the following conditions might lead a financial manager to delay a positive-NPV project? (Assume that project NPV-if undertaken immediately-is held constant.)