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Exam 13: Real Options

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Question 1

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

A) True
B) False

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Question 2

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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.

A) True
B) False

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Question 3

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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.

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

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.

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

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.

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?

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?

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

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.

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.

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?

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.

Which one of the following statements is most CORRECT?

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?

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.

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.

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.

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?