32)
Year 0 Year 0 Year 1 Year 2
Revenue $15,000 $15,000
Variable Cost ($5,000) ($5,000)
Depreciation ($200) ($200)
Fixed Cost ($350) ($350)
Operating
Income $9,450 $9,450
Taxes at 30% ($2,835) ($2,835)
NOPAT $6,615 $6,615
Capital
Investment ($5,753)
Free Cash
Flow $6,815 $6,815
NPV $6,074.69
Forecasts for project ST are shown above. Using a discount rate of 10%, the project has a
positive NPV of $6,074.69. Estimate within $100 the level of sales revenue that will result in an
NPV of $0.00. No other variables will change.
Topic: 13.3 Break-Even Analysis
Keywords: NPV break-even
Principles: Principle 2: There Is a Risk-Return Tradeoff
1) Which of the following is a real option with respect to a capital budgeting decision?
A) A call option on the company’s stock.
B) A put option on securities sold to finance the project.
C) An option to expand the scale of the project.
D) An option to purchase that will be used for the manufacturing facility.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
28
2) Real options can have the effect of:
A) increasing a project’s NPV.
B) reducing a project’s risk.
C) gaining information about future opportunities.
D) all of the above.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
Enrico, the owner of a pizza parlor near a large university campus, is considering opening a shop
specializing in quick, inexpensive take-out meals that are low in fat and calories. He will use a
vacant space adjacent to the pizza parlor. Assume that the project requires an initial cash outlay
of $100,000. Finance students from the university have taken on the project as a course
assignment. They believe that there is a 50% chance that the project will have modest success
and return $11,000 per year for the foreseeable future (a perpetuity). On the other hand, there is a
50% chance that the project will be highly successful and produce returns of $20,000 per year in
perpetuity. If the restaurant is modestly successful, Enrico will keep it open, but not expand. If it
is well received, he will immediately open 2 more shops at sites close to the sprawling campus.
3) What is the project’s NPV if success is modest and it is not expanded?
A) $10,000
B) ($10,000)
C) $110,000
D) The present value of a perpetual cash flow cannot be determined.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
4) What is the NPV of the project if it is expanded?
A) $100,000
B) $500,000
C) $300,000
D) $600,000
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
29
5) What is the expected NPV of the project with the option to expand?
A) $310,000
B) $155,000
C) $110,000
D) $300,000
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
6) What is the expected NPV of the project with the option to expand if the probability of modest
success is revised to 70% and great success to 30%?
A) $310,000
B) $155,00 (no change)
C) $213,000
D) $97,000
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
An alternative energy project will cost $300,000. Depending on the price of electricity, the
project will create after–tax savings of either $100,000 per year for 5 years or $75,000 per year
for 5 years. If first year savings are only $75,000, the project can be sold at the end of the first
year for $250,000. Use a discount rate of 10%.
7) What is the NPV of the project if first year savings are only $75,000 and the project is not
sold.
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
30
8) What is the NPV of the project if first year savings are only $75,000 and the project is sold.
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
9) What is the expected NPV of the project if the option to abandon is not considered.
A) ($4,545)
B) $31,694
C) $37,267
D) $63,388
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
10) What is the expected NPV of the project if the option to abandon is considered.
A) ($4,545)
B) $31,694
C) $37,267
D) $63,388
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
31
Use the following information to answer the following question(s).
Tropical Soft Drinks is evaluating a proposal to install solar panels on the roof of it’s factory near
San Juan. The panels will cost $150,000 per set. Depending on the price of electricity and the
efficiency of the panels, the project will increase operating cash flows by either $50,000 per year
or $75,000 per year. The useful life of the panels is 5 years. If early results indicate savings of
$75,000 per year, four additional sets of panels will be installed immediately at the same cost
11) What is the expected NPV of the project if the option to expand is not considered.
A) $39,539
B) $86,924
C) $236,924
D) $134,309
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
12) What is the expected NPV of the project if the option to expand is considered.
A) $355,542
B) $671,545
C) $236,924
D) $711,084
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
13) Tennessee Fried Chicken is evaluating a proposal to open a fast food restaurant in
Westphalia. The restaurant will cost $14.5 million to open. Expected cash flows are $4 million
per year for the first five years. At the end of 5 years, the government of Westphalia will either
revoke TFC‘s permit and the restaurant will close, or renew the permit indefinitely. In that case,
assume that the $4 million turns into a perpetuity. There is a 30% chance the permit will be
revoked and a 70% chance it will be renewed. Compute the expected NPV of the project. Use a
discount rate of 12%.
A) $18.83 million
B) ($.08 million)
C) $13.16 million
D) $9.43 million
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
32
14) Which of the following is NOT a typical real option in capital budgeting?
A) The option to expand the project
B) The option to abandon the project
C) The option to reduce the scale of a project
D) The option to discount the project at a lower rate of return
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
15) Real options can be either calls, options to buy the project, or calls, options to sell the
project.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
16) When evaluating projects with real options, businesses must consider the probability that the
option will be exercised.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
17) One type of real option is to delay the beginning of a project until conditions are more
favorable.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
18) The holder of the patent on a new energy efficient, long lived light bulb that gives off a warm
yellow light and does not contain mercury intends to manufacture and market it over the internet.
Which of the following possibilities represent real options?
A) Sell the patent to a major manufacturer after 2 or 3 years.
B) Expand production and sell the product through major retailers.
C) Delay the launch of the website until energy prices rise.
D) All of the above.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
33
19) Briefly explain what is meant by a real option in capital budgeting. Give 2 concrete
examples.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
20) The NPV of a project based on forecasted cash flows is $1,000,000. There is a 40%
probability that cash flows from the project will be seriously reduced because competitors will
enter the market. In this case, if the company did nothing, the NPV would be ($500,000). The
project can also be abandoned after 2 years and NPV will be ($100,000). What is the expected
NPV of the project when the option to abandon is considered. Should the projected be accepted?
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
21) Why is it important to consider real options in the capital budgeting process? Give two
specific examples.
Topic: 13.4 Real Options in Capital Budgeting
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
34