Chap022.pdf

Chapter 22 - Real Options

Chapter 22 Real Options Multiple Choice Questions

1. The following are the main types of real options: I) The option to expand if the immediate investment project succeeds II) The option to wait (and learn) before investing III) The option to shrink or abandon a project IV) The option to vary the mix of output or the firm's production methods A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV only

2. The following are examples of applications of real options analysis: I) A strategic investment in the computer business. II) The valuation of an aircraft purchase option. III) The option to develop commercial real estate. IV) The decision or mothball an oil tanker. A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

3. Managers who hold real options can view: A. themselves as passive onlookers with no decision making opportunities. B. these as tools for reducing the total risk of the firm through diversification. C. these as opportunities to alter management decisions in the future. D. themselves as agents who are looking for higher compensation.

22-1


4. The opportunity to invest in a project can be thought of as a three-year real option that is worth $500 million with an exercise price of $800 million. Calculate the value of the option given that, N(d1) = 0. 3 and N(d2) = 0.15. Assume that the interest is 6% per year. A. $150 million B. $49.25 million C. Zero D. None of the above.

5. The opportunity to invest in a project can be thought of as a two year option on an asset which is worth $400 million (PV of the cash flows from the project) with an exercise price of $600 million (investment needed). Calculate the value of the option given that N(d1) = 0.6 and N(d2) = 0.4 and interest rate is 6%. A. $26.4 million B. Zero C. $200 million. D. None of the above.

6. The discounted cash flow (DCF) approach must be: A. Augmented by added analysis if there are no imbedded options. B. Augmented by added analysis if a decision has significant imbedded options. C. Jettisoned if there are any embedded options. D. Computed carefully to identify the options.

7. The following are examples of expansion options: I) A mining company may acquire rights to an ore body that is not worth developing today but could be profitable if product prices increase II) A film producing company acquiring the rights to a novel to produce a film based on the novel in the future III) A real estate developer may acquire a parcel of land that could be turned into a shopping mall IV) A pharmaceutical company may acquire a patent to market a new drug A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

22-2


8. The opportunity to defer investing to a later date may have value because: I) The cost of capital may increase in the near future. II) Uncertainty may be increased in the future. III) Investment costs fluctuate over time. IV) Market conditions may change and increase the NPV of the project. A. I only B. I and II only C. III only D. IV only

Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (C0) and is expected to remain constant. The price of oil P is $40/bbl and the extraction costs are $25/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes).

9. Calculate the NPV to invest today. A. +40 million B. +75 million C. +25 million D. None of the above

10. Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then expected NPV of the project if postponed by one year is: (approximately) A. +50 million B. -25 million C. +59 million D. None of the above

22-3


11. Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then the value of the option to postpone the project by one year is: A. +34 million B. +25 million C. +59 million D. None of the above

12. An abandonment option, in effect, A. limits the flexibility of management's decision-making. B. limits the downside risk of an investment project. C. limits the profit potential of a proposed project. D. applies only to new projects.

13. A project is worth $15 million today without an abandonment option. Suppose the value of the project is $20 million one year from today with high demand and $10 million with low demand. It is possible to sell off the project for $13 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the replicating portfolio method] A. $1.21 million. B. $2.86 million. C. $1.9 million. D. None of the above.

14. A project is worth $12 million today without an abandonment option. Suppose the value of the project is $18 million one year from today with high demand and $8 million with low demand. It is possible to sell off the project for $10 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the risk-neutral valuation] A. $1.03 million. B. $2 million. C. $1.9 million. D. None of the above.

22-4


15. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (C0) and is expected to remain constant. The price of oil P is $60/bbl and the extraction costs are $35/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes). The firm has constructed the oil rig and a year later the oil price has plummeted to $30/bbl. The firm can cap the rig at a cost of $10 million. The firm can restart pumping when oil is price more favorable. Calculate the NPV of capping the rig: (abandonment option). A. +$25 million B. +$10 million C. +$15 million D. None of the above

16. Given the following data for Project X: NPV of the project without abandonment: -$2 million; abandonment option value: $4 million. Calculate the adjusted present value (APV) of the project: A. -$2 million B. +$4 million C. +$2 million D. none of the above

17. Which of the following statements about a project's economic life is (are) true? A. most project's economic lives are not known with certainty at the start. B. a new product may last only for a year or less if the product fails in the marketplace. C. a new product if successful, could last for several years (with improvements or variations). D. all of the above are true.

22-5


18. Rejecting an investment today forever might not be a good choice because: I) The size of the firm will decline. II) There are always errors in the estimation of the NPVs. III) The option value is negative. IV) The company is foregoing future rights or the option to make the investment if economic and industry conditions change for the better. A. I only B. II only C. I, II, and III only D. IV only

19. Which of the following statements about the option to build flexibility into production facilities is (are) true? A. Typically is more expensive. B. Must consider the NPV of alternative uses. C. May be valuable by allowing reconfiguration to produce of goods or service with higher profit. D. All of the above are true.

20. Which of the following conditions might lead a financial manager to delay a positive NPV project? Assume project NPV if undertaken immediately is held constant. A. The risk-free interest rate falls. B. Uncertainty about future project value increases. C. The first cash inflow generated by the project is lower than previously thought. D. Investment required for the project increases.

21. Which of the following conditions might lead a financial manager to decide to expedite a positive Net Present Value investment project that previously he/she had decided to delay? A. The risk-free interest rate increases. B. Uncertainty about future project value increases. C. The cash inflows generated by the project is lower than previously thought. D. Investment required for the project is expected to increase in the near future.

22-6


22. In terms of a real option, the cash flows from the project play the same role as: A. The stock price. B. The exercise price. C. The dividends. D. The variance.

23. An example of a real option is: A. The option to make follow-on investments. B. The option to abandon a project. C. The option to wait before investing. D. all of the above.

24. A rational manager may be reluctant to commit to a positive Net Present Value project when: A. The value of the option to abandon is high. B. The exercise price is high. C. The opportunity cost of capital is high. D. The value of the option to wait is high.

25. Production facilities that are flexible in terms of possible raw materials used are most valuable when: A. Product demand is highly volatile. B. Product price is highly volatile. C. Raw material prices are highly volatile. D. Labor costs are highly volatile.

22-7


26. Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be the least valuable to have co-firing equipment? Let a c be the annual standard deviation of coal prices, and let a n be the annual standard deviation of natural gas prices, and p the correlation between coal prices and natural gas prices. A. a c high, a n high, p low. B. a c high, a n low, p low. C. a c low, a n high, p low. D. a c low, a n low, p high.

27. Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be most valuable to have co-firing equipment? Let a c be the annual standard deviation of coal prices, and let a n be the annual standard deviation of natural gas prices, and p the correlation between coal prices and natural gas prices. A. a c high, a n high, p low. B. a c high, a n low, p low. C. a c low, a n high, p low. D. a c low, a n low, p high.

28. A firm in the extraction industry whose major assets are cash, equipment and a closed facility may appear to have extraordinary value. This value can be primarily attributed to: A. The potential sale of the company. B. The low exercise price held by the shareholders. C. The option to open the facility when prices rise dramatically. D. All of the above.

22-8


29. The difference between the NPV of the investment and the value of the option to invest is: I) The value for the option to invest still have a positive value at high interest rates while the NPV could be negative. II) The value of the option to invest has a negative value at low interest rates while NPV could have high positive value. III) The value of the option to invest and the NPV of the project are unrelated. A. I only B. II only C. III only D. II and III only

30. If projects have implied options. A. The shorter the available life of the project the less valuable the option is. B. The longer the available life of the project the less valuable the option is. C. The shorter the available life of the project the more valuable the option is. D. Available project life does not change the value option.

31. Tech Com announces a major expansion into Internet services. This announcement causes the price of Tech Com stock to increase, but also causes an increase in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the call option of Tech Com? A. Both changes cause the price of the call option to decrease B. Both changes cause the price of the call option to increase C. The greater uncertainty will cause the price of the call option to decrease. The higher price of the stock will cause the price of the call option to increase D. The greater uncertainty will cause the price of the call option to increase. The higher price of the stock will cause the price of the call option to decrease

22-9


32. Imagine that you are the producer of Harry Potter films. You are trying to decide whether to film the next two Harry Potter movies at the same time. If you film them both at once, you can save money on production costs, but you could lose a lot of money if the first one flops and no one goes to see the second one. Specifically, if you film them both at once, it will cost a total of $300 million, but if you film them separately, they will cost $200 million each. If the first one is successful, it will have revenues of $1 billion and the second one will have revenues of $1.5 billion. If the first one fails, it will only have revenues of $150 million and the second one will have revenues of only $50 million. If you decide to film them separately and the first one flops, you don't have to film the second one. The first film has a 50% chance of succeeding and a 50% chance of failing. Assume that all figures are given as present values (you do not need to do any additional discounting). Should you film both of them now or film them separately? Why? A. Film them together now as E(NPV) = $1,050 million B. Film them separately as E(NPV) = $1,125 million C. Film them separately as E(NPV) = $1,025 million D. None of the above

33. You are considering making a "Hillary" action figure to capitalize on what you are sure will be a massive resurgence political fever. Production will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present value (PV)). If the voters do not catch the political fever, you will only sell action figures worth $2 (in PV) million as only loyal democrats will buy. Each has a 50% chance of happening. Before beginning production, you can conduct a marketing survey to determine which scenario will happen. The survey costs $1 million. Is it worth conducting the survey? Why? A. Do not conduct the survey as the E(NPV without survey) = +$6 million B. Conduct the survey as the E(NPV with survey) = $6.5 million C. Do not conduct the survey as the E(NPV with survey) = $5 million D. None of the above

34. The following are practical challenges in applying real-options analysis: I) real options can be complex II) the real options problems may not be well structured III) competition may reduce or change the value of real options A. I only B. I and II only C. III only D. I, II and III

22-10


35. The owner of a pro football team expects the team to be worth either $270 million next year or $120 million, depending on whether or not she gets the city to build a new stadium. There is a 60% chance she will get a new stadium. There is a buyer willing to pay $175 million for the team, but will not keep the offer open without some form of compensation. Given a discount rate of 7%, how much should she be willing to pay for the option to sell the team? A. 0 B. $21 million C. $42 million D. $55 million

36. If an oil well allows the investor the option to drill later, what must happen for the option to be exercised? A. Increase in interest rates B. The probability of oil prices increasing must be less than the probability price decreases C. Oil prices must exceed the present value of future expected oil prices D. The present value of oil must be higher than the future value of oil

True / False Questions

37. The option to make follow-on investment is a put option. True False

38. The option to expand is a type of financial option. True False

39. The option to wait is a type of real option. True False

40. In real options, required investment is considered the exercise price. True False

22-11


41. APV = NPV (without expansion option) + Value of the expansion option. True False

42. Adjusted present value of project (APV) = NPV (without abandonment option) + Value of abandonment option. True False

43. The first step in a real options analysis is to value the underlying asset using discounted cash flow (DCF) method. True False

44. The binomial method can be used for most abandonment options. True False

45. Real options analysis can be used to link project life to the performance of the project. True False

46. Temporary abandonment is a very simple real option that allows the firm to stop a project temporarily until the conditions improve. True False

47. An electric utility plant that may be designed to operate on either oil or natural gas is an example of flexibility in production. True False

48. Risk-neutral approach is an application of the certainty equivalent method. True False

22-12


49. Real estate developers who buy options on farm land around a big city expect to exercise most of their options. True False

50. The owner of a professional sports franchise, looking to get a new stadium, would benefit from a put option if the deal falls through. True False

Short Answer Questions

51. What are the four main types of real options?

52. How can managers create real options? Briefly explain.

53. How does an option to wait or postpone a project add value to the project?

22-13


54. How does an abandonment option increase the value of a project?

55. Explain the main difference between the Black-Scholes formula and the binomial method.

56. Briefly explain how abandonment value can be used to determine the project life.

57. Briefly explain how temporary abandonment can be thought of as complex options.

22-14


58. Explain the difference between the value of a project and the value of real options associated with project.

59. Briefly explain the implied assumption when risk-neutral method is used for valuing real options.

60. Briefly discuss three practical problems associated with real options analysis.

61. How does a firm like Intel hold a natural real option on a new technology, where as a smaller firm would not have the same option if they owned the same technology?

22-15


Chapter 22 Real Options Answer Key

Multiple Choice Questions

1. The following are the main types of real options: I) The option to expand if the immediate investment project succeeds II) The option to wait (and learn) before investing III) The option to shrink or abandon a project IV) The option to vary the mix of output or the firm's production methods A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV only

Type: Easy

2. The following are examples of applications of real options analysis: I) A strategic investment in the computer business. II) The valuation of an aircraft purchase option. III) The option to develop commercial real estate. IV) The decision or mothball an oil tanker. A. I only B. I and II only C. I, II, and III only D. I, II, III and IV

Type: Easy

22-16


3. Managers who hold real options can view: A. themselves as passive onlookers with no decision making opportunities. B. these as tools for reducing the total risk of the firm through diversification. C. these as opportunities to alter management decisions in the future. D. themselves as agents who are looking for higher compensation.

Type: Medium

4. The opportunity to invest in a project can be thought of as a three-year real option that is worth $500 million with an exercise price of $800 million. Calculate the value of the option given that, N(d1) = 0. 3 and N(d2) = 0.15. Assume that the interest is 6% per year. A. $150 million B. $49.25 million C. Zero D. None of the above. C = 500(0.3) - (0.15)(800)/(1.06^3) = 49. 25

Type: Medium

5. The opportunity to invest in a project can be thought of as a two year option on an asset which is worth $400 million (PV of the cash flows from the project) with an exercise price of $600 million (investment needed). Calculate the value of the option given that N(d1) = 0.6 and N(d2) = 0.4 and interest rate is 6%. A. $26.4 million B. Zero C. $200 million. D. None of the above. C = 400(0.6) - (0.4)(600)/(1.06^2) = 26.4

Type: Medium

22-17


6. The discounted cash flow (DCF) approach must be: A. Augmented by added analysis if there are no imbedded options. B. Augmented by added analysis if a decision has significant imbedded options. C. Jettisoned if there are any embedded options. D. Computed carefully to identify the options.

Type: Medium

7. The following are examples of expansion options: I) A mining company may acquire rights to an ore body that is not worth developing today but could be profitable if product prices increase II) A film producing company acquiring the rights to a novel to produce a film based on the novel in the future III) A real estate developer may acquire a parcel of land that could be turned into a shopping mall IV) A pharmaceutical company may acquire a patent to market a new drug A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

Type: Easy

8. The opportunity to defer investing to a later date may have value because: I) The cost of capital may increase in the near future. II) Uncertainty may be increased in the future. III) Investment costs fluctuate over time. IV) Market conditions may change and increase the NPV of the project. A. I only B. I and II only C. III only D. IV only

Type: Difficult

22-18


Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (C0) and is expected to remain constant. The price of oil P is $40/bbl and the extraction costs are $25/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes).

9. Calculate the NPV to invest today. A. +40 million B. +75 million C. +25 million D. None of the above NPV today = [(40 - 25)(300,000)]/(0.06) - 50,000,000 = + 25,000,000 = 25 million

Type: Difficult

10. Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then expected NPV of the project if postponed by one year is: (approximately) A. +50 million B. -25 million C. +59 million D. None of the above NPV(oil price = $50/bbl) = (60 - 25)(300,000)/0.06 - 50,000,000 = + 125,000,000 NPV(oil price = $30/bbl) = (30 - 25)(300,000)/0.06 - 50,000,000 = - 25,000,000 (reject ) NPV(oil price = $30/bbl) = 0; (We only invest if the oil price next year is $60/bbl) Expected NPV = [(0.5) (0) + (0.5) (125,000,000)]/1.06 = 62,500,000/1.06 = $59 million

Type: Difficult

22-19


11. Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then the value of the option to postpone the project by one year is: A. +34 million B. +25 million C. +59 million D. None of the above Value of the Option to Wait = 59 - 25 = $34 million

Type: Difficult

12. An abandonment option, in effect, A. limits the flexibility of management's decision-making. B. limits the downside risk of an investment project. C. limits the profit potential of a proposed project. D. applies only to new projects.

Type: Easy

13. A project is worth $15 million today without an abandonment option. Suppose the value of the project is $20 million one year from today with high demand and $10 million with low demand. It is possible to sell off the project for $13 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the replicating portfolio method] A. $1.21 million. B. $2.86 million. C. $1.9 million. D. None of the above. 20A + 1.05B = 0; 10A + 1.05B = 3; A = -0.3 and B = 5.71; P = -0.3(12) + 5.71 = 1.21

Type: Difficult

22-20


14. A project is worth $12 million today without an abandonment option. Suppose the value of the project is $18 million one year from today with high demand and $8 million with low demand. It is possible to sell off the project for $10 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the risk-neutral valuation] A. $1.03 million. B. $2 million. C. $1.9 million. D. None of the above. 12 = [(18)(X) + (8)(1 - X)]/1.05; X = 0.46; (1 - X) = 0.54; P = (2)(0.54)/1.05 = 1.03

Type: Difficult

15. Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (C0) and is expected to remain constant. The price of oil P is $60/bbl and the extraction costs are $35/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes). The firm has constructed the oil rig and a year later the oil price has plummeted to $30/bbl. The firm can cap the rig at a cost of $10 million. The firm can restart pumping when oil is price more favorable. Calculate the NPV of capping the rig: (abandonment option). A. +$25 million B. +$10 million C. +$15 million D. None of the above PV (continue to pump oil) = (30 - 35)(300,000)/(0.06) = -25 million PV (capping the rig) = -10 million; NPV of capping = + 15 million

Type: Medium

22-21


16. Given the following data for Project X: NPV of the project without abandonment: -$2 million; abandonment option value: $4 million. Calculate the adjusted present value (APV) of the project: A. -$2 million B. +$4 million C. +$2 million D. none of the above APV = -2 + 4 = +4

Type: Easy

17. Which of the following statements about a project's economic life is (are) true? A. most project's economic lives are not known with certainty at the start. B. a new product may last only for a year or less if the product fails in the marketplace. C. a new product if successful, could last for several years (with improvements or variations). D. all of the above are true.

Type: Easy

18. Rejecting an investment today forever might not be a good choice because: I) The size of the firm will decline. II) There are always errors in the estimation of the NPVs. III) The option value is negative. IV) The company is foregoing future rights or the option to make the investment if economic and industry conditions change for the better. A. I only B. II only C. I, II, and III only D. IV only

Type: Difficult

22-22


19. Which of the following statements about the option to build flexibility into production facilities is (are) true? A. Typically is more expensive. B. Must consider the NPV of alternative uses. C. May be valuable by allowing reconfiguration to produce of goods or service with higher profit. D. All of the above are true.

Type: Difficult

20. Which of the following conditions might lead a financial manager to delay a positive NPV project? Assume project NPV if undertaken immediately is held constant. A. The risk-free interest rate falls. B. Uncertainty about future project value increases. C. The first cash inflow generated by the project is lower than previously thought. D. Investment required for the project increases.

Type: Medium

21. Which of the following conditions might lead a financial manager to decide to expedite a positive Net Present Value investment project that previously he/she had decided to delay? A. The risk-free interest rate increases. B. Uncertainty about future project value increases. C. The cash inflows generated by the project is lower than previously thought. D. Investment required for the project is expected to increase in the near future.

Type: Medium

22. In terms of a real option, the cash flows from the project play the same role as: A. The stock price. B. The exercise price. C. The dividends. D. The variance.

Type: Medium

22-23


23. An example of a real option is: A. The option to make follow-on investments. B. The option to abandon a project. C. The option to wait before investing. D. all of the above.

Type: Medium

24. A rational manager may be reluctant to commit to a positive Net Present Value project when: A. The value of the option to abandon is high. B. The exercise price is high. C. The opportunity cost of capital is high. D. The value of the option to wait is high.

Type: Medium

25. Production facilities that are flexible in terms of possible raw materials used are most valuable when: A. Product demand is highly volatile. B. Product price is highly volatile. C. Raw material prices are highly volatile. D. Labor costs are highly volatile.

Type: Medium

22-24


26. Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be the least valuable to have co-firing equipment? Let a c be the annual standard deviation of coal prices, and let a n be the annual standard deviation of natural gas prices, and p the correlation between coal prices and natural gas prices. A. a c high, a n high, p low. B. a c high, a n low, p low. C. a c low, a n high, p low. D. a c low, a n low, p high.

Type: Medium

27. Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be most valuable to have co-firing equipment? Let a c be the annual standard deviation of coal prices, and let a n be the annual standard deviation of natural gas prices, and p the correlation between coal prices and natural gas prices. A. a c high, a n high, p low. B. a c high, a n low, p low. C. a c low, a n high, p low. D. a c low, a n low, p high.

Type: Medium

28. A firm in the extraction industry whose major assets are cash, equipment and a closed facility may appear to have extraordinary value. This value can be primarily attributed to: A. The potential sale of the company. B. The low exercise price held by the shareholders. C. The option to open the facility when prices rise dramatically. D. All of the above.

Type: Medium

22-25


29. The difference between the NPV of the investment and the value of the option to invest is: I) The value for the option to invest still have a positive value at high interest rates while the NPV could be negative. II) The value of the option to invest has a negative value at low interest rates while NPV could have high positive value. III) The value of the option to invest and the NPV of the project are unrelated. A. I only B. II only C. III only D. II and III only

Type: Difficult

30. If projects have implied options. A. The shorter the available life of the project the less valuable the option is. B. The longer the available life of the project the less valuable the option is. C. The shorter the available life of the project the more valuable the option is. D. Available project life does not change the value option.

Type: Medium

31. Tech Com announces a major expansion into Internet services. This announcement causes the price of Tech Com stock to increase, but also causes an increase in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the call option of Tech Com? A. Both changes cause the price of the call option to decrease B. Both changes cause the price of the call option to increase C. The greater uncertainty will cause the price of the call option to decrease. The higher price of the stock will cause the price of the call option to increase D. The greater uncertainty will cause the price of the call option to increase. The higher price of the stock will cause the price of the call option to decrease

Type: Difficult

22-26


32. Imagine that you are the producer of Harry Potter films. You are trying to decide whether to film the next two Harry Potter movies at the same time. If you film them both at once, you can save money on production costs, but you could lose a lot of money if the first one flops and no one goes to see the second one. Specifically, if you film them both at once, it will cost a total of $300 million, but if you film them separately, they will cost $200 million each. If the first one is successful, it will have revenues of $1 billion and the second one will have revenues of $1.5 billion. If the first one fails, it will only have revenues of $150 million and the second one will have revenues of only $50 million. If you decide to film them separately and the first one flops, you don't have to film the second one. The first film has a 50% chance of succeeding and a 50% chance of failing. Assume that all figures are given as present values (you do not need to do any additional discounting). Should you film both of them now or film them separately? Why? A. Film them together now as E(NPV) = $1,050 million B. Film them separately as E(NPV) = $1,125 million C. Film them separately as E(NPV) = $1,025 million D. None of the above E(NPV(filming together)) = -300 + (0.5)(1,000 + 1,500) + (0.5)(200) = $1,050 Million E(NPV(film separately) = -200 + (0.5)(1,000 - 200 + 1500) + 0.5(150) = $1025 Million

Type: Difficult

33. You are considering making a "Hillary" action figure to capitalize on what you are sure will be a massive resurgence political fever. Production will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present value (PV)). If the voters do not catch the political fever, you will only sell action figures worth $2 (in PV) million as only loyal democrats will buy. Each has a 50% chance of happening. Before beginning production, you can conduct a marketing survey to determine which scenario will happen. The survey costs $1 million. Is it worth conducting the survey? Why? A. Do not conduct the survey as the E(NPV without survey) = +$6 million B. Conduct the survey as the E(NPV with survey) = $6.5 million C. Do not conduct the survey as the E(NPV with survey) = $5 million D. None of the above E(NPV without survey) = -5 + (0.5)(20) + (0.5)(2) = +$6 million E(NPV with survey) = -1 + (0.5)( - 5 + 20) + (0.5)(0) = +6.5 million

Type: Difficult

22-27


34. The following are practical challenges in applying real-options analysis: I) real options can be complex II) the real options problems may not be well structured III) competition may reduce or change the value of real options A. I only B. I and II only C. III only D. I, II and III

Type: Medium

35. The owner of a pro football team expects the team to be worth either $270 million next year or $120 million, depending on whether or not she gets the city to build a new stadium. There is a 60% chance she will get a new stadium. There is a buyer willing to pay $175 million for the team, but will not keep the offer open without some form of compensation. Given a discount rate of 7%, how much should she be willing to pay for the option to sell the team? A. 0 B. $21 million C. $42 million D. $55 million The value of the team without the option is a binomial calculation. Without Option Value = (270 * .6 + 120 * .4)/1.07 = $196 mil With option Value = (270 * .6 + 120 * .4)/1.07 = $217 mil Option value = 217 - 196 = $21 million

Type: Difficult

36. If an oil well allows the investor the option to drill later, what must happen for the option to be exercised? A. Increase in interest rates B. The probability of oil prices increasing must be less than the probability price decreases C. Oil prices must exceed the present value of future expected oil prices D. The present value of oil must be higher than the future value of oil

Type: Medium

22-28


True / False Questions

37. The option to make follow-on investment is a put option. FALSE

Type: Medium

38. The option to expand is a type of financial option. FALSE

Type: Easy

39. The option to wait is a type of real option. TRUE

Type: Medium

40. In real options, required investment is considered the exercise price. TRUE

Type: Medium

41. APV = NPV (without expansion option) + Value of the expansion option. TRUE

Type: Easy

22-29


42. Adjusted present value of project (APV) = NPV (without abandonment option) + Value of abandonment option. TRUE

Type: Easy

43. The first step in a real options analysis is to value the underlying asset using discounted cash flow (DCF) method. TRUE

Type: Medium

44. The binomial method can be used for most abandonment options. TRUE

Type: Medium

45. Real options analysis can be used to link project life to the performance of the project. TRUE

Type: Medium

46. Temporary abandonment is a very simple real option that allows the firm to stop a project temporarily until the conditions improve. FALSE

Type: Medium

22-30


47. An electric utility plant that may be designed to operate on either oil or natural gas is an example of flexibility in production. TRUE

Type: Easy

48. Risk-neutral approach is an application of the certainty equivalent method. TRUE

Type: Medium

49. Real estate developers who buy options on farm land around a big city expect to exercise most of their options. FALSE

Type: Medium

50. The owner of a professional sports franchise, looking to get a new stadium, would benefit from a put option if the deal falls through. TRUE

Type: Medium

Short Answer Questions

51. What are the four main types of real options? I) Option to expand if the immediate investment project is a success. II) The option to wait (and learn) before investing. III) The option to shrink or abandon a project. IV) The option to vary the mix of output or the firm's production methods.

Type: Medium

22-31


52. How can managers create real options? Briefly explain. Managers are not passive onlookers in a firm. They can make decisions to capitalize on good fortunes or to mitigate losses. By adding flexibility to the firm's investments and operations decisions, managers can create real options and thereby adding value to the firm.

Type: Medium

53. How does an option to wait or postpone a project add value to the project? The option to wait or postpone a project is equivalent to owning a call option on the investment project. The option is exercised when the firm invests in the project. It is often preferable to defer the project in order to keep the call alive. Deferral is most attractive when uncertainty is large. Hence the value of the project is increased by the presence of the real option.

Type: Medium

54. How does an abandonment option increase the value of a project? The option to abandon a project, a put option, provides partial insurance against failure and hence increases the value of a project. It can also be thought of as providing only downside limit to projects and thereby increasing the value of the projects.

Type: Easy

22-32


55. Explain the main difference between the Black-Scholes formula and the binomial method. The Black-Scholes formula is a continuous time model whereas the binomial method uses discrete time intervals. Therefore binomial method is more useful for evaluating real options. The binomial approach converges to the Black-Scholes method when the time interval is very small. Also u (1 + up%) is equal to (e^σÖh) where σ is the standard deviation per year and h is the time interval as a fraction of a year. (1 + down %) is 1/u. These relationships are used to switch between Balck-Scholes formula and the binomial model.

Type: Medium

56. Briefly explain how abandonment value can be used to determine the project life. Most projects' economic lives are not known at the start. In standard DCF capital-budgeting analysis, the life of the project is fixed arbitrarily. For example, cash flows from a new product may last only for a year or less if the product fails in the marketplace. But if the product is successful, then the product or its variations or improvements could be produced for very many years. Real options analysis allows us to arrive at the projects life using financial logic. Here we forecast a range of possible cash flows well beyond the best guess of project's economic life. Then the value of the project, including its abandonment value, is used, in the best upside scenarios and also in the worst downside scenarios, to analyze the life of the project. This procedure links project life to the performance of the project and does not impose an arbitrary ending date.

Type: Medium

22-33


57. Briefly explain how temporary abandonment can be thought of as complex options. Firms are often face situations that allow them to abandon a project temporarily until conditions improve. A project cannot be turned on and off like a faucet. There is a fixed cost to temporarily stopping a project. Unless you are sure of the adverse economic conditions, you do not want to incur the fixed cost. Similarly, you do not want to restart a temporarily abandoned project unless you are sure of the changed conditions are for the better. There are a range of values between which abandonment and restart occur. Beyond this range either the project is running or the abandoned project remains abandoned. These can be thought of as complex options.

Type: Medium

58. Explain the difference between the value of a project and the value of real options associated with project. The value of a project is the present value of all the cash flows from a project. It is usually calculated using discounted cash flow method. The value of a real option on the project comes from the opportunity to change or modify the cash flow from the project.

Type: Difficult

59. Briefly explain the implied assumption when risk-neutral method is used for valuing real options. When risk-neutral method is used valuing a real option we implicitly assume that these options are traded in an efficient market. Risk-neutral method gives option values if it were to be traded in the efficient market. Conceptually, it is same as certainty equivalent method.

Type: Medium

22-34


60. Briefly discuss three practical problems associated with real options analysis. I) Real options can be complex, and valuing them may be difficult and time consuming. II) Real options analysis applications to practical problems may be unstructured and solving these problems can get complicated quickly. III) Analyzing the real options applications when competitive firms can alter project payoffs may involve use of game theory.

Type: Difficult

61. How does a firm like Intel hold a natural real option on a new technology, where as a smaller firm would not have the same option if they owned the same technology? The ability to commercialize a new technology is not the same for all firms. A company like Intel has research, development, production, and distribution capability not possessed by smaller firms. The option to make a follow up investment and produce a significant profit, therefore, is an option that maybe unique to Intel and not a smaller firm. Thus, new technology may be worth more to Intel than a smaller competitor.

Type: Difficult

22-35

Chap022.pdf

Recommend Documents