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Exam 13: Real Options and Other Topics in Capital Budgeting

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Question 1

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Multiple Part: 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 $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 be poor 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 $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 20.00% cost of capital is used. ​ ​ -Refer to Exhibit 13.1 and to previous problem.Calculate the project's coefficient of variation.(Hint: Use the expected NPV as found in previous problem.)

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

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

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Question 2

Multiple Choice

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Multiple Part: 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 $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 be poor 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 $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 20.00% cost of capital is used. ​ ​ -Refer to Exhibit 13.1.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

F) A) and B)
G) B) and D)

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Question 3

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

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)protection options,(2)flexibility options,(3)timing options,and (4)abandonment options.

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.

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.

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

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

Carlson Inc.is evaluating a project in India that would require a $6.2 million investment today (t = 0) .The after-tax cash flows would depend on whether India imposes a new property tax.There is a 50-50 chance that the tax will pass,in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years.If the tax doesn't pass,the after-tax cash flows will be $2,000,000 for 5 years.The project has a WACC of 12.0%.The firm would have the option to abandon the project 1 year from now,and if it is abandoned,the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1.If the project is abandoned,the company would receive no further cash inflows from it.What is the value (in thousands) of this abandonment option?

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?

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."

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

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.

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.

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.

Which one of the following is NOT a real option?

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 very low.

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.

Chrustuba Inc.is evaluating a new project that would cost $9 million at t = 0.There is a 50% chance that the project would be highly successful and generate annual after-tax cash flows of $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 $10 million at the end of Year 2,and this new investment could be sold for $20 million at the end of Year 3.Assuming a WACC of 10.0%,what is the project's expected NPV (in thousands) after taking into account this growth option? ​