Deck 20: Decision Trees, Real Options, and Other Capital Budgeting Techniques

Question 1

Which of the following best describes real options?

A) Real options change the size, but not the risk, of projects' expected cash flows.
B) Real options change the risk, but not the size, of projects' expected cash flows.
C) Real options are likely to 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.

Answer 1

C

Question 2

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

Answer 2

False

Question 3

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 Question 12.)

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

Answer 3

C

Question 4

Nebraska Pharmaceuticals Company (NPC) is considering a project that has an up-front cost at t = 0 of $1,500. (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 Health Canada. If Health Canada 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 1 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 Health Canada'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).
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 , relative to the NPV if it proceeds today?

A) $77.23
B) $85.81
C) $95.34
D) $105.94

Question 5

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

Question 6

Now assume that 1 year from now OI will know if the F-100 has become the industry standard. Also assume that after receiving the cash flows at t = 1, OI 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?

A) $2,075
B) $4,067
C) $8,945
D) $10,745

Question 7

Lighthouse Corporation 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?

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 not considering 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.

Question 8

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

Question 9

Commodore Corporation 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 could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Commodore decides to wait. Which of the following statements best describes the issues that
Commodore faces when considering this investment timing option?

A) The more uncertainty about the future cash flows, the more logical it is for Commodore to go ahead with this project today.
B) Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year.
C) Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
D) Waiting would probably reduce the project's risk.

Question 10

Based on the above information, what is the F-200's expected net present value?

A) -$6,678
B) -$3,251
C) $15,303
D) $20,004

Question 11

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.

Question 12

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

A) lengthening the time in 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

Question 13

Which 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 goes up
C) the option to expand into a new geographic region
D) the option to switch the type of fuel used in an industrial furnace

Question 14

Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties, and then selling the successful ones to major oil refining companies. TWI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. 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.
T = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at 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.
T = 2. If the exploratory wells test positive, TWI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at 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.
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 receiving only a $10,000 inflow.
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?

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

Question 15

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

Question 16

If Diplomat 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 favourable, 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 unfavourable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Diplomat.com 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?

A) -$1,104,607
B) -$875,203
C) $199,328
D) $561,947

Question 17

In the previous problem you found the benefit from delaying an investment decision. Now use the same data to calculate the effect of waiting on the project's risk. By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV as found in Question 14.)

A) 2.23
B) 2.46
C) 2.70
D) 2.97

Question 18

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 a year.
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.

Question 19

Based on the above data, what is the project's net present value?

A) -$1,312,456
B) -$1,104,607
C) -$875,203
D) $105,999