Deck 14: Real Options

Question 1

Mead, Inc. may invest $20 million in a new fiber optic project. Due to market conditions, annual production costs and revenues are forecasted at $10 million and $8 million, respectively, starting next year. Revenues are expected to grow at 4.0% and interest rates are 6.0%. What is the change in value if the project is commenced in 5 years instead of today? (Use static analysis.)

A) $8.84 million
B) $10.84 million
C) $12.84 million
D) $14.84 million

Answer 1

B

Question 2

What is the value of the project assuming an $80 annual cost?

A) $10.86
B) $13.81
C) $33.52
D) $47.33

Answer 2

B

Question 3

The current price of gold is $310.00 per ounce. The effective lease rate and risk free rate are 1.0% and 3.5%, respectively. If the cost to mine one ounce of gold is a constant $250, what is the value of an option to wait and mine the gold later?

A) $135
B) $145
C) $155
D) $165

Answer 3

B

Question 4

The phrase in real option theory used to replace the strike price?

A) Exercise
B) Investment
C) PV of asset
D) Trend

Question 5

The price of oil is $22 per barrel. The effective lease rate and risk free rate are 5.0% and 6.0%, respectively. The constant cost of extraction is $18 per barrel and the volatility of prices is 18.0%. What is the value of an option to defer extraction?

A) $5.34
B) $6.34
C) $7.34
D) $8.34

Question 6

The price of oil is $45 per barrel. The effective lease rate and risk free rate are 3.0% and 4.0%, respectively. The constant cost of extraction is $25 per barrel and the volatility of prices is 15.0%. If an untapped well costs $240 to open and can produce indefinitely, at what price per barrel should the well be opened?

A) $34
B) $44
C) $54
D) $64

Question 7

The price of oil is $45 per barrel. The effective lease rate and risk free rate are 3.0% and 4.0%, respectively. The constant cost of extraction is $25 per barrel and the volatility of prices is 15.0%. If an untapped well costs $240 to open and can produce indefinitely, what is the value of the unopened well?

A) $424
B) $554
C) $635
D) $785

Question 8

What is another term used to describe the forward price?

A) Certainty equivalent
B) Elasticity
C) Risk neutral price
D) Value

Question 9

Given the requirement of an $80 annual expenditure, what is the elasticity of the cash flows in period 1, with respect to the scenario in which no investment is required?

A) 1.40
B) 7.08
C) 9.68
D) 11.62

Question 10

Use a binomial tree to value to following option. Assume r_f = 0.045, r_p = 0.14, σ = 0.20, E(CF₁) = $62 million, g = 0.03, time horizon = 2 years, binomial period = 1 year, and cost = $500 million. What is the value of this project option?

A) $47 million
B) $57 million
C) $67 million
D) $77 million

Question 11

An existing well is operating and the price of oil is $45 per barrel. The effective lease rate and risk free rate are 3.0% and 4.0%, respectively. The constant cost of extraction is $25 per barrel and the volatility of prices is 15.0%. If it costs nothing to shut down the well, at what price would we close the well?

A) $12
B) $25
C) $37
D) $49

Question 12

Given the requirement of an $80 annual cost, what is the value of the option to abandon the project in periods where the cash flows are negative?

A) $10.86
B) $13.81
C) $33.52
D) $47.33

Question 13

If we continue to consider the $80 annual cost, but are able to avoid operating in years where money will be lost, what is the expected risk neutral cash flow in year 2?

A) $2.12
B) $14.36
C) $80.00
D) $82.12

Question 14

If the project has an $80 annual cost requirement, what is the first year risk neutral expected cash flow?

A) $93.99
B) $87.54
C) $13.99
D) $7.54

Question 15

When answering the questions below, refer to the following table and related data.
Project Cash Flow Tree From a New Project
$$\begin{array} { r r r } \text { Year 1 } & \text { Year 2 } & \text { Year 3 } \\120.52 & 155.67 & 222.64 \\65.24 & \mathbf { 8 4 . 2 7 } & 120.52 \\& 45.62 & \mathbf { 6 5 . 2 4 } \\& & 35.32\end{array}$$ Effective annual risk free rate = 4.5% Expected market return = 10%
Cash flow beta = 1.4
The true probability of the high cash flow in a given period is 52.0%.

-What is the risk neutral probability of an upward movement in the project cash flows during the first year of operations?

A) 35.6%
B) 40.3%
C) 48.1%
D) 59.7%

Question 16

What is the value of the project assuming an $80 annual cost and the option of not pursing the project in periods where cash flow is negative?

A) $10.86
B) $13.81
C) $33.52
D) $47.33

Question 17

When answering the questions below, refer to the following table and related data.
Project Cash Flow Tree From a New Project
$$\begin{array} { r r r } \text { Year 1 } & \text { Year 2 } & \text { Year 3 } \\120.52 & 155.67 & 222.64 \\65.24 & \mathbf { 8 4 . 2 7 } & 120.52 \\& 45.62 & \mathbf { 6 5 . 2 4 } \\& & 35.32\end{array}$$ Effective annual risk free rate = 4.5% Expected market return = 10%
Cash flow beta = 1.4
The true probability of the high cash flow in a given period is 52.0%.

-What is the risk neutral probability of the first two years of the project cash flows moving down?

A) 40.3%
B) 48.0%
C) 52.0%
D) 59.7%

Question 18

Use a binomial tree to value the following option. Assume r_f = 0.04, r_p =0.12, σ = 0.35, E(CF₁) = $30, and cost = $300. What is the value of this project option?

A) $40.74
B) $50.60
C) $55.32
D) $62.12

Question 19

Techie, Inc. may invest $5 million in a new Star Communicator project. Annual production costs and revenues are projected to be $2 million and $1.5 million, with each growing at 2.0% and 4.0%, respectively. At an interest rate of 5.5%, what is the approximate investment year that will maximize value? (Use static analysis.)

A) Year 20
B) Year 15
C) Year 10
D) Year 5

Question 20

What is the value of the project if the true probabilities are used and the appropriate one period risk adjusted discount rate is used (assume the $80 annual cost does not exist)?

A) $169.65
B) $201.42
C) $233.73
D) $288.64

Question 21

In the context of peak-load energy generation and a European exchange option, what is the spark spread?

Question 22

Why is the perpetual call formula used to price commodity extraction options?

Question 23

Why is the Black Scholes formula not viable when pricing a spread option for electricity?

Question 24

What feature of the abandonment option makes the use binomial pricing more appealing than the Black Scholes pricing model?

Question 25

What is the main difference in pricing R & D options versus most other real options?