Deck 13: Real Options

Question 1

It is not possible for abandonment options to decrease a project's risk as measured by the project's coefficient of variation.

Answer 1

False

Question 2

The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options.

Answer 2

False

Question 3

The following are all examples of real options that are discussed in the text: (1) protection options, (2) flexibility options, (3) timing options, and (4) abandonment options.

Answer 3

False

Question 4

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

Question 5

Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no reason to consider real options separately from the NPV analysis.

Question 6

The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option.

Question 7

Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice--delay the decision until later, when more information will be available. Because the analysis extends out at least one additional year from the original analysis, it is unlikely that the firm would ever delay a project--particularly given the loss of the "first mover advantage."

Question 8

An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project's sponsors and explaining why any differences occurred.

Question 9

The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options, (3) timing options, and (4) abandonment options.

Question 10

Traditional discounted cash flow (DCF) analysis--where a project's cash flows are estimated and then discounted to obtain an expected NPV--has been the cornerstone of capital budgeting since the 1950s. However, in recent years, it has been demonstrated that DCF techniques do not always lead to proper capital budgeting decisions due to the existence of real options.

Question 11

The optimal capital budget is the size of the capital budget where the rate of return on the marginal project is equal to the marginal cost of capital.

Question 12

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

Question 13

Real options exist whenever 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.

Question 14

Real options can affect the size of a project's expected NPV but not project's risk as measured by the standard deviation or coefficient of variation of the NPV.

Question 15

If a firm practices capital rationing, this means that it is accepting fewer projects than would be theoretically optimal; hence, it is not maximizing its theoretical value.

Question 16

A firm's optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive projects that have the highest positive NPVs.

Question 17

Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice--delay the decision until later, when more information will be available.

Question 18

For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC.

Question 19

Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has.

Question 20

Real options are most valuable when the underlying source of risk--such as uncertainty about unit sales, or the sales price, or input costs--is very low.

Question 21

Weisbach Electronics is considering investing in India. Which of the following factors would make the company less likely to proceed with the investment?

A) The company would have the option to withdraw from the investment after 2 years if it turns out to be unprofitable.
B) The investment would increase the odds of the company being able to subsequently make a successful entry into China.
C) The investment would preclude the company from being able to make a profitable investment in China.
D) Competitors are considering similar investments in India, and the firm can discourage them from trying by entering now.
E) The new plant could be easily retrofitted to manufacture many of the firm's other products.

Question 22

Winters Corp. is considering a new product that would require an investment of $20 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $10 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $4 million per year. There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak, but it would have to incur costs to obtain this timing option. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's WACC is 11.0%. What is the value (in thousands) of the option to delay the project?

A) $1,311
B) $1,457
C) $1,619
D) $1,799
E) $1,999

Question 23

In the previous problem you were asked to find the expected NPV of a project TWI is considering. Use the same data to calculate the project's coefficient of variation. (Hint: Use the expected NPV as found in Problem 40.)

A) 5.87
B) 6.52
C) 7.25
D) 7.97
E) 8.77

Question 24

Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?

A) The abandonment option tends to reduce a project's NPV.
B) The abandonment option tends to reduce a project's risk.
C) If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project.
D) A project can either have an abandonment option or an investment timing option, but never both.
E) Investment timing options always increase the value of a project.

Question 25

Norris Production Company (NPC)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 $2,500, the subsequent cash flows will remain at $750 per year if the competitor's product is rejected and $50 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)This is a risky project, so a WACC of 16.0% is to be used. If NPC chooses to wait a year before proceeding, what is the value of the timing option today?

A) $124.22
B) $138.02
C) $153.36
D) $170.40
E) $187.44

Question 26

Carlson Inc. is evaluating a project in India that would require a $6.2 million investment today (t = 0). The after-tax cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12.0%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the value (in thousands) of this abandonment option?

A) $104
B) $115
C) $128
D) $141
E) $155

Question 27

Texas Wildcatters Inc. (TWI)t = 0. A $400 feasibility study would be conducted at 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. There is an 80% probability that the feasibility study would indicate that an exploratory well should be drilled. There is a 20% probability that no further work would be done.
T = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill an exploratory well. The best estimate is that there is a 60% probability that the exploratory well would indicate good potential and thus that further work would be done, and a 40% probability that the outlook would look bad and the project would be abandoned.
T = 2. If the exploratory well tests positive, the firm would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2.
T = 3. 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.
Since the project is considered to be quite risky, a 20.0% cost of capital is used. What is the project's expected NPV, in thousands of dollars?

A) $336.15
B) $373.50
C) $415.00
D) $461.11
E) $507.22

Question 28

Which one of the following statements best describes the most likely impact that a profitable abandonment option would have on a project's expected cash flow and risk?

A) No impact on the PV of expected cash flows, but risk will increase.
B) The PV of expected cash flows increases and risk decreases.
C) The PV of expected cash flows increases and risk increases.
D) The PV of expected cash flows decreases and risk decreases.
E) The PV of expected cash flows decreases and risk increases.

Question 29

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

A) Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account.
B) Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.
C) Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact the failure to consider real options has on the overall capital budget.
D) Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.
E) Real options should not have any effect on the size of the optimal capital budget.

Question 30

High Roller Properties is considering building a new casino at a cost of $10 million at t = 0. The after-tax cash flows the casino generates will depend on whether the state imposes a new income tax, and there is a 50-50 chance the tax will pass. If it passes, after-tax cash flows will be $1.875 million per year for the next 5 years. If it doesn't pass, the after-tax cash flows will be $3.75 million per year for the next 5 years. The project's WACC is 11.0%. If the tax is passed, the firm will have the option to abandon the project 1 year from now, in which case the property could be sold to net $6.5 million after tax at t = 1. What is the value (in thousands) of this abandonment option?

A) $202
B) $224
C) $249
D) $277
E) $308

Question 31

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

A) A company has an option to invest in a project today or to wait for a year before making the commitment.
B) A company has an option to close down an operation if it turns out to be unprofitable.
C) A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change.
D) A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
E) A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly a commercial airline.

Question 32

Games Unlimited Inc. is considering a new game that would require an investment of $20.0 million. If the new game is well received, then the project would produce cash flows of $9.5 million a year for 3 years. However, if the market does not like the new game, then the cash flows would be only $6.0 million per year. There is a 50% probability of both good and bad market conditions. The firm could delay the project for a year while it conducts a test to determine if demand would be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. If the WACC is 9.0%, what is the value (in thousands) of the investment timing option?

A) $1,857
B) $2,042
C) $2,246
D) $2,471
E) $2,718

Question 33

Chrustuba Inc. is evaluating a new project that would cost $9 million at t = 0. There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $6 million during Years 1, 2, and 3. However, there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the project is highly successful, it would open the door for another investment of $10 million at the end of Year 2, and this new investment could be sold for $20 million at the end of Year 3. Assuming a WACC of 10.0%, what is the project's expected NPV (in thousands) after taking into account this growth option?

A) $2,776
B) $3,085
C) $3,393
D) $3,733
E) $4,106

Question 34

Which one of the following statements is most CORRECT?

A) Real options change the size, but not the risk, of projects' expected NPVs.
B) Real options change the risk, but not the size, of projects' expected NPVs.
C) Real options can reduce the cost of capital that should be used to discount a project's expected cash flows.
D) Very few projects actually have real options. They are theoretically interesting but of little practical importance.
E) Real options are more valuable when there is very little uncertainty about the true values of future sales and costs.

Question 35

Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following statements best describes the issues that the firm faces when considering this investment timing option?

A) The investment timing option would not affect the cash flows and therefore would have no impact on the project's risk.
B) The more uncertainty about the future cash flows, the more logical it is to go ahead with this project today.
C) Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if the firm chooses to wait a year.
D) Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
E) Waiting would probably reduce the project's risk.

Question 36

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

A) Lengthening the time during which a real option must be exercised.
B) An increase in the volatility of the underlying source of risk.
C) An increase in the risk-free rate.
D) An increase in the cost of obtaining the real option.
E) A decrease in the probability that a competitor will enter the market of the project in question.

Question 37

Which of the following statements is CORRECT?

A) In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment.
B) In general, the greater the strategic advantages of being the first competitor to enter a given market, the more attractive it probably is to wait before making an investment.
C) In general, the higher the discount rate, the more attractive it probably is to wait before making an investment.
D) In general, investment timing options are more valuable than abandonment options.
E) In general, abandonment options are rarely seen in the real world.

Question 38

Which one of the following is NOT a real option?

A) The option to expand production if the product is successful.
B) The option to buy shares of stock if its price is expected to increase.
C) The option to expand into a new geographic region.
D) The option to abandon a project if cash flows turn out to be lower than expected.
E) The option to switch the type of fuel used in an industrial furnace to lower the cost of production.

Question 39

Lindley Corp. is considering a new product that would require an investment of $10 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $2 million per year. There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's WACC is 10.0%. What is the value (in thousands) of the project after considering the investment timing option?

A) $ 726
B) $ 807
C) $ 896
D) $ 996
E) $1,106