Deck 12: Capital Budgeting: Risk Analysis and Real Options

Question 1

The textbook suggests that real options may be especially important for multinational firms. Which of the following observations tend to support this contention?

A) Multinational firms that can exploit the internal corporate market to their advantage tend to have more flexibility than purely domestic firms to alter the economic cash flows generated by their operating assets and preserve profitability.
B) MNEs have to worry less about the actions of competitors than purely domestic companies, so they have more discretion about the timing of foreign projects (they have a much larger window of opportunity).
C) MNEs wield greater economic and, thus, political power than many of the nations in which they operate, so they are able to expand or abandon foreign projects far more easily than would be the case in a domestic setting without having to worry about how the host government will react.
D) All of the statements above are reasons real options are especially important for MNEs.
E) Only statements a and b are correct.

Answer 1

Multinational firms that can exploit the internal corporate market to their advantage tend to have more flexibility than purely domestic firms to alter the economic cash flows generated by their operating assets and preserve profitability.

Question 2

The textbook suggests that while risk analysis is important for most kinds of domestic projects, it is even more vital for foreign investments. The reasons why this statement is correct include all of the following statements except

A) MNEs usually have an expanded opportunity set of projects with high return potential but also with higher levels of stand-alone risk.
B) Many components of project cash flows from all perspectives, but particularly from the parent perspective, are driven by host government political considerations rather than by market-driven economic forces, and thereby add a new dimension to the risk of foreign projects.
C) Even though OPIC insurance can protect the firm against many important sources of foreign risks, it does not cover everything, so unique foreign risks still exist on top of the usual risks of a domestic project.
D) Experienced managers develop "gut feelings" about aspects of domestic projects that allow them to forecast important variables quite reliably, but they find it far more difficult to make reliable forecasts when the cash flows are being generated in a foreign context.
E) All of the statements above are reasons risk analysis is more important for foreign projects.

Answer 2

All of the statements above are reasons risk analysis is more important for foreign projects.

Question 3

Hartley Corp. is considering a project that could be a "make-it-or-break-it" project for the firm. Using its managers' input variable estimates, the project has a positive NPV = $334,492. Naturally, Hartley is quite concerned about the input variables it has used. A sensitivity analysis has been performed on a few of the key variables. Below, are the values of the resulting NPVs if the corresponding input variable is changed by 1 percent. What is the sensitivity index of the variable that has the most importance in terms of the project's value?

A) 10.1%
B) -13.8%
C) 18.4%
D) -19.7%
E) 20.8%

Answer 3

-19.7%

Question 4

McGaven & Associates is considering an investment in a proposed project. Rather than making the investment today, the company wants to wait a year to collect additional information about the project. It will not have to invest any cash flows until it decides to make the investment. If it waits a year, there is a 25 percent chance the project's expected NPV one year from today will be $10 million, a 50 percent chance that the project's expected NPV one year from now will be $4 million, and a 25 percent chance that the project's expected NPV one year from now will be -$10 million. All expected cash flows are discounted at 10 percent. What is the expected NPV in today's dollars, if the company chooses to wait a year before deciding whether to make the investment?

A) $2.9889 million
B) $3.1496 million
C) $3.6875 million
D) $4.0909 million
E) $4.5000 million

Question 5

Carhart Towers Inc. is considering a proposed project. The company estimates that if it invests in the project today, the project's estimated NPV is $10 million, but there remains a lot of uncertainty about the project's profitability.
As an alternative to making the investment today, the company is considering waiting a year. In particular, it is considering spending some money today to collect additional information, which would enable the firm to make a better assessment of the project's value one year from now. Carhart believes that if it waits a year, there is a 50 percent chance the information collected will be positive and the project's expected NPV one year from now (not including the cost of obtaining the information) will be $25 million. There is also a 50 percent chance the information collected will be negative and the project's expected NPV one year from now (not including the cost of obtaining the information) will be -$12 million.
If the company chooses to collect additional information, the costs of collecting this information will be incurred today. Moreover, if the company chooses to wait a year, it has the option to invest or not invest in the project after receiving the information about the project's prospects. Assume that all cash flows are discounted at 11 percent. What is the maximum amount of money the company would be willing to spend to collect this information?

A) $1.009 million
B) $1.261 million
C) $1.502 million
D) $1.793 million
E) $2.500 million

Question 6

Brett Co. just purchased a new delivery truck. The new truck cost $25,000 and is expected to generate net after-tax operating cash flows, including depreciation, of $7,000 at the end of each year. The truck has a 5-year expected life. The expected abandonment values (salvage values after tax adjustments) at different points in time are given below. (Note that these abandonment value estimates assume that the truck is sold after receiving the project's cash flow for the year.) The firm's cost of capital is 10 percent.
At what point in time would the company choose to sell (abandon) the truck in order to maximize its NPV?

A) After one year
B) After two years
C) After three years
D) After four years
E) The company should not abandon the project.

Question 7

Cosgrove Technologies is considering a project that has an up-front cost of $3 million and produces an expected cash flow of $500,000 at the end of each of the next five years. The project's cost of capital is 10 percent.
If Cosgrove goes ahead with this project today, the project will create additional opportunities five years from now (t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information that is available today, the company estimates that there is a 35 percent chance that its technology will be successful, in which case the future investment opportunities will have a net present value of $6 million at t = 5. There is a 65 percent chance that its technology will not succeed, in which case the future investment opportunities will have a net present value of -$6 million at t = 5. Cosgrove does not have to decide today whether it wants to pursue these additional opportunities. Instead, it can wait until after it finds out if its technology is successful. However, Cosgrove cannot pursue these additional opportunities in the future unless it makes the initial investment today. What is the estimated net present value of the project today, after taking into account the future opportunities?

A) $199,328
B) $561,947
C) $898,205
D) -$1,104,607
E) -$2,222,265

Question 8

Differentiate between stand-alone, corporate, and market risk.

Question 9

Describe abandonment, growth, investment timing, and flexibility options.

Question 10

Describe some methods of analyzing project stand-alone risk.

Question 11

Explain how a real option on a project is similar to a call option on a stock.

Question 12

What is a variable importance matrix?

Question 13

Jimmerson Properties is considering a project that could be a "make-it-or-break-it" project for the firm. Using its managers' input variable estimates, the project has a positive NPV = $212,549. Naturally, Jimmerson is quite concerned about the input variables it has used. A sensitivity analysis has been performed on a few of the key variables. Below, are the values of the resulting NPVs if the corresponding input variable is changed by 1 percent. What is the sensitivity index of the variable that has the most importance in terms of the project's value?

Question 14

Stephens Construction is considering an investment in a proposed project. Rather than making the investment today, the company wants to wait a year to collect additional information about the project. It will not have to invest any cash flows until it decides to make the investment. If it waits a year, there is a 25 percent chance the project's expected NPV one year from today will be $12 million, a 50 percent chance that the project's expected NPV one year from now will be $5 million, and a 25 percent chance that the project's expected NPV one year from now will be -$8 million. All expected cash flows are discounted at 12 percent. What is the expected NPV in today's dollars, if the company chooses to wait a year before deciding whether to make the investment?

Question 15

Wendt Publishing is considering a proposed project. The company estimates that if it invests in the project today, the project's estimated NPV is $20 million, but there remains a lot of uncertainty about the project's profitability.
As an alternative to making the investment today, the company is considering waiting a year. In particular, it is considering spending some money today to collect additional information, which would enable the firm to make a better assessment of the project's value one year from now. Wendt believes that if it waits a year, there is a 50 percent chance the information collected will be positive and the project's expected NPV one year from now (not including the cost of obtaining the information) will be $55 million. There is also a 50 percent chance the information collected will be negative and the project's expected NPV one year from now (not including the cost of obtaining the information) will be -$15 million.
If the company chooses to collect additional information, the costs of collecting this information will be incurred today. Moreover, if the company chooses to wait a year, it has the option to invest or not invest in the project after receiving the information about the project's prospects. Assume that all cash flows are discounted at 10 percent. What is the maximum amount of money the company would be willing to spend to collect this information?

Question 16

Persia Shipping just purchased a new delivery truck. The new truck cost $30,000 and is expected to generate net after-tax operating cash flows, including depreciation, of $8,000 at the end of each year. The truck has a 5-year expected life. The expected abandonment values (salvage values after tax adjustments) at different points in time are given below. (Note that these abandonment value estimates assume that the truck is sold after receiving the project's cash flow for the year.) The firm's cost of capital is 10 percent.
At what point in time would the company choose to sell (abandon) the truck in order to maximize its NPV?

Question 17

White Industries is considering a project that has an up-front cost of $4 million and produces an expected cash flow of $900,000 at the end of each of the next five years. The project's cost of capital is 10 percent.
If White goes ahead with this project today, the project will create additional opportunities five years from now (t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information that is available today, the company estimates that there is a 30 percent chance that its technology will be successful, in which case the future investment opportunities will have a net present value of $8 million at t = 5. There is a 70 percent chance that its technology will not succeed, in which case the future investment opportunities will have a net present value of -$6 million at t = 5. White does not have to decide today whether it wants to pursue these additional opportunities. Instead, it can wait until after it finds out if its technology is successful. However, White cannot pursue these additional opportunities in the future unless it makes the initial investment today. What is the estimated net present value of the project today, after taking into account the future opportunities?

Question 18

Angelo Fibers is considering a project with an up-front cost of $250,000. The project's subsequent cash flows critically depend on whether its products become the industry standard. There is a 50 percent chance that the products will become the industry standard, in which case the project's expected cash flows will be $110,000 at the end of each of the next five years. There is a 50 percent chance that the products will not become the industry standard, in which case the project's expected cash flows will be $25,000 at the end of each of the next five years. Assume that the cost of capital is 12 percent.
Now assume that one year from now Angelo will know if its products will have become the industry standard. Also assume that after receiving the cash flows at t = 1, the company has the option to abandon the project. If it abandons the project it will receive an additional $100,000 at t = 1, but will no longer receive any cash flows after t = 1. Assume that the abandonment option does not affect the cost of capital. What is the estimated value of the abandonment option?