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Exam 13: Real Options and Other Topics in Capital Budgeting

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Question 1

True/False

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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.

A) True
B) False

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Question 2

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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.

F) A) and C)
G) C) and D)

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Question 3

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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.

Norris Production Company (NPC) is considering a project that has an up-front cost at t = 0 of $2,400.(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 the Food and Drug Administration.If the FDA 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 50% chance that the competitive product will be rejected,in which case NPC's expected cash flows will be $700 at the end of each of the next seven years (t = 1 to 7) .There is a 50% chance that the competitor's product will be approved,in which case the expected cash flows will be only $50 at the end of each of the next seven years (t = 1 to 7) .NPC will know for sure one 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 about the FDA's decision.If it waits a year,the project's up-front cost at t = 1 will remain at $2,400,the subsequent cash flows will remain at $700 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) .In addition,once NPC knows the outcome of the FDA's decision,it will not take on the project if its NPV is negative. ? 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 (in thousand) of the timing option today? Do not round intermediate calculations. ?

Langston Labs has an overall (composite) WACC of 10%,which reflects the cost of capital for its average asset.Its assets vary widely in risk,and Langston evaluates low-risk projects with a WACC of 8%,average-risk projects at 10%,and high-risk projects at 12%.The company is considering the following projects: $\begin{array}{ccc}\text { Project } & \text { Risk } & \text { Expected Return } \\\text { A } & \text { High } & 15 \% \\\text { B } & \text { Average } & 12 \% \\\text { C } & \text { High } & 11 \% \\\text { D } & \text { Low } & 9 \% \\\text { E } & \text { Low } & 6 \%\end{array}$ ? Which set of projects would maximize shareholder wealth?

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?

Games Unlimited Inc.is considering a new game that would require an investment of $21.0 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 $6.8 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 9.6%,what is the value (in thousands) of the investment timing option? Do not round intermediate calculations. ?

Which one of the following is NOT a real option?

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.

High Roller Properties is considering building a new casino at a cost of $10.0 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 $6.7 million after tax at t = 1.What is the value (in thousands) of this abandonment option? Do not round intermediate calculations. ?

Winters Corp.is considering a new product that would require an investment of $22 million now,at t = 0.If the new product is well received,then the project would produce after-tax cash flows of $11.0 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 10.0%.What is the value (in thousands) of the option to delay the project? Do not round intermediate calculations. ?

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.

Which of the following statements is CORRECT?

The following 2 problems must be kept together. The first problem can be used alone, but use the second problem ONLY if the first problem is also used. Exhibit 13.1 Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties, then selling the successful ones to major oil companies. It is now considering a new potential field, and its geologists have developed the following data, shown in thousands of dollars. * t = 0 A $350 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 $1,200 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 be poor and the project would be abandoned. * t = 2 If the exploratory well tests positive, the firm would go ahead and spend $8,000 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 $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then receiving only a $8,000 inflow. * Since the project is considered to be quite risky, a 18.00% cost of capital is used. -Refer to Exhibit 13.1 and to the previous problem.Calculate the project's coefficient of variation.(Hint: Use the expected NPV as found in previous problem. )

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

Chrustuba Inc.is evaluating a new project that would cost $8.6 million at t = 0.There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $5.6 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 $11 million at the end of Year 2,and this new investment could be sold for $22 million at the end of Year 3.Assuming a WACC of 9.5%,what is the project's expected NPV (in thousands) after taking into account this growth option? Do not round intermediate calculations. ​

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?

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.

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