Exam 14: Real Options

Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option?

Real options affect the size, but not the risk, of a project's expected cash flows.

Nationwide Pharmaceutical Corporation A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved. NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7). -Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Calculate the effect of waiting on the project's risk, using the same data. By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV.)

Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds.

Real options are most valuable when the underlying source of risk is very low.

Which of the following is NOT a real option?

Which one of the following is an example of a "flexibility" option?

Which of the following is most CORRECT?

Drilling Experts, Inc. Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. $\mathrm{t}=0$ $\quad$$\quad$ A $\$ 400$ feasibility study would be conducted at $\mathrm{t}=0$ . The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project. $\mathrm{t}=1$ $\quad$$\quad$ If the feasibility study indicates good potential, the firm would spend $\$ 1,000$ at $\mathrm{t}=1$ to drill exploratory wells. The best estimate is that there is an $80 \%$ probability that the exploratory wells would indicate good potential and thus that further work would be done, and a $20 \%$ probability that the outlook would look bad and the project would be abandoned. $\mathrm{t}=2$ $\quad$$\quad$ If the exploratory wells test positive, DEI would go ahead and spend $\$ 10,000$ to obtain an accurate estimate of the amount of oil in the field at $\mathrm{t}=2$ . The best estimate now is that there is a $60 \%$ probability that the results would be very good and a $40 \%$ probability that results would be poor and the field would be abandoned. $\mathrm{t}=3$ $\quad$$\quad$ If the full drilling program is carried out, there is a $50 \%$ probability of finding a lot of oil and receiving a $\$ 25,000$ cash inflow at $t=3$ , and a $50 \%$ probability of finding less oil and then only receiving a $\$ 10,000$ inflow. -Refer to the data for Drilling Experts. Calculate the project's coefficient of variation. (Hint: Use the expected NPV.)

Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation?

Steppingstone Incorporated The Zσ90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Zσ45, becomes an industry standard. There is a 50% chance that the Zσ45 will become the industry standard, in which case the Zσ90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Zσ45 will not become the industry standard, in which case the Zσ90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%. -Refer to data for Steppingstone Incorporated (SI). Now assume that one year from now SI will know if the Zσ45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?

Which of the following will NOT increase the value of a real option?

Nationwide Pharmaceutical Corporation A project with an up-front cost at t = 0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC). (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor's product has been approved. NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7). -Refer to the data for Nationwide Pharmaceutical Corporation (NPC). Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project's expected NPV in today's dollars (i.e., at t = 0), relative to the NPV if it proceeds today?

Garner-Wagner Incorporated The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%. -Refer to the data for Garner-Wagner Incorporated. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of σ$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?

Garner-Wagner Incorporated The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%. -Refer to the data for Garner-Wagner Incorporated.Based on the above data, what is the project's net present value?

Steppingstone Incorporated The Zσ90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Zσ45, becomes an industry standard. There is a 50% chance that the Zσ45 will become the industry standard, in which case the Zσ90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Zσ45 will not become the industry standard, in which case the Zσ90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%. -Refer to data for Steppingstone Incorporated. Based on the above information, what is the Zσ90's expected net present value?

The option to abandon a project is a real option, but a call option on a stock is not a real option.

Drilling Experts, Inc. Drilling Experts, Inc. (DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies. DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. $\mathrm{t}=0$ $\quad$$\quad$ A $\$ 400$ feasibility study would be conducted at $\mathrm{t}=0$ . The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project. $\mathrm{t}=1$ $\quad$$\quad$ If the feasibility study indicates good potential, the firm would spend $\$ 1,000$ at $\mathrm{t}=1$ to drill exploratory wells. The best estimate is that there is an $80 \%$ probability that the exploratory wells would indicate good potential and thus that further work would be done, and a $20 \%$ probability that the outlook would look bad and the project would be abandoned. $\mathrm{t}=2$ $\quad$$\quad$ If the exploratory wells test positive, DEI would go ahead and spend $\$ 10,000$ to obtain an accurate estimate of the amount of oil in the field at $\mathrm{t}=2$ . The best estimate now is that there is a $60 \%$ probability that the results would be very good and a $40 \%$ probability that results would be poor and the field would be abandoned. $\mathrm{t}=3$ $\quad$$\quad$ If the full drilling program is carried out, there is a $50 \%$ probability of finding a lot of oil and receiving a $\$ 25,000$ cash inflow at $t=3$ , and a $50 \%$ probability of finding less oil and then only receiving a $\$ 10,000$ inflow. -Refer to the data for Drilling Experts, Incorporated. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project's expected NPV, in thousands of dollars?

Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project's cash flows.