35)
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.
Question Status: Previous edition
Objective: 13.3 Use break-even analysis to evaluate project risk.
Keywords: break-even analysis
Principles: Principle 2: There Is a Risk–Return Tradeof
31
13.4 Real Options in Capital Budgeting
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 inance the project.
C) An option to expand the scale of the project.
D) An option to purchase land that will be used for a manufacturing facility.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
2) Real options can have the efect of
A) increasing a project’s NPV.
B) reducing a project’s risk.
C) gaining information about future opportunities.
D) all of the above.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
32
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. The additional
shops would have approximately the same cash low as the irst. Cash lows will be
discounted at 10%.
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 low cannot be determined.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
33
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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) $155,000 (no change)
C) $213,000
D) $97,000
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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 irst year savings are only $75,000, the project can be sold at the end of
the irst year for $250,000. Use a discount rate of 10%.
7) What is the NPV of the project if irst year savings are only $75,000 and the project is
not sold?
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
34
8) What is the NPV of the project if irst year savings are only $75,000 and the project is
sold?
A) ($4,545)
B) ($15,691)
C) $15,691
D) $75,000
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
35
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 its factory
near San Juan. The panels will cost $150,000 per set. Depending on the price of electricity
and the eiciency of the panels, the project will increase operating cash lows 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 with the same projected savings. The probability of either
outcome is 50%. Use a discount rate of 10%.
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
36
13) Bufalo Drumsticks is evaluating a proposal to open a restaurant in Bermuda. The
restaurant will cost $29 million to open. Expected cash lows are $8 million per year for the
irst ive years. At the end of 5 years, the government of Bermuda will either revoke BD’s
permit and the restaurant will close, or renew the permit indeinitely. If the permit is
revoked, the building and equipment can be sold for $10,000,000. If the permit is
renewed, assume that the $8 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) $37.66 million
B) ($15.16 million)
C) $28.02 million
D) $18.86 million
Question Status: New question
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
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
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
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.
Question Status: Previous edition
37
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
18) Real options are traded on both the American Exchange and Chicago Board Options
Exchange (CBOE).
Question Status: New question
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
19) Real options are derivative securities that derive their value from the value of the
underlying projects.
Question Status: New question
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
20) Projects may appear to have less risk when real options are considered.
Question Status: New question
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
21) Briely explain what is meant by a real option in capital budgeting. Give 2 concrete
examples.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
38
22) The NPV of a project based on forecasted cash lows is $1,000,000. There is a 40%
probability that cash lows 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?
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
23) Why is it important to consider real options in the capital budgeting process? Give two
speciic examples.
Question Status: Previous edition
Objective: 13.4 Describe the types of real options.
Keywords: real options
Principles: Principle 3: Cash Flows Are the Source of Value
39