Deck 13: Real Options and Other Topics in Capital Budgeting

Question 1

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

Answer 1

True

Question 2

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

Answer 2

True

Question 3

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.

Answer 3

True

Question 4

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 5

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 6

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 7

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.

Question 8

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

Question 9

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 10

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 low.

Question 11

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

Question 12

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.

Question 13

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 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

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 16

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 17

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 18

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 19

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 20

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 21

In the previous problem you found the benefit from delaying an investment decision. Now use the same data to calculate the effect the delay will have on the project's risk: By how much will delaying to obtain more information reduce the project's coefficient of variation? (Hint: Use the expected NPV as found in Problem 40.)

A) 6.31
B) 6.94
C) 7.63
D) 8.39
E) 9.23

Question 22

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 23

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 24

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 25

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 38.)

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

Question 26

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 27

Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor's larger competitors, Online Professor (OP), is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won't be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?

A) $161.46
B) $179.40
C) $199.33
D) $219.26
E) $241.19

Question 28

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) few projects actually have real options. They are theoretically interesting but of little practical importance.
E) Real options are more valuable when there is little uncertainty about the true values of future sales and costs.

Question 29

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 30

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 31

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 32

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 33

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, how much will this increase or decrease the project's expected NPV in today's dollars? (Hint: Find the NPV for "go now" and for "wait," then discount the wait-NPV back for one year since it will occur one year later, and then find the difference between the two NPVs.)

A) $253.86
B) $282.06
C) $313.40
D) $348.22
E) $383.05