Chapter: Chapter 35: Flexibility
True/False
1. Regardless of the level of uncertainty, it is possible to value assets or a project using a
standard discounted cash flow (DCF) approach or a stochastic simulation. However, in cases
when managers can decide among different alternatives in response to certain events,
contingent valuation approaches are useful.
2. Flexibility is typically more relevant in the valuation of individual businesses and projects, as
it mostly concerns detailed decisions related to production, capacity investment, marketing,
and research and development (R&D).
3. The value of flexibility is lowest when:
a) Uncertainty is high and managers can react to new information.
b) Uncertainty is low and managers can react to new information.
c) Uncertainty is high and managers cannot react to new information.
d) Uncertainty is low and managers cannot react to new information.
4. List the three approaches that managers can take when flexibility is neither expected nor
required to value assets or projects and the level of uncertainty under which each works best.
5. List the two contingent valuation approaches. Identify which one is more sophisticated and
explain when the less sophisticated approach might be preferred.
6. Which of the following is NOT true concerning real-option valuation (ROV)?
a) ROV is theoretically superior to decision tree analysis.
b) In practice, ROV cannot always replace decision tree analysis.
c) In practice, ROV can replace traditional discounted cash flow analysis.
d) In practice, ROV is well suited to decisions in commodity-based businesses.
7. A project’s contingent net present value (NPV) will always be greater than or equal to its
standard NPV.
8. The value of flexibility is greatest when uncertainty is high and managers can react to new
information.
9. Which of the following is most accurate concerning how a change in interest rates can
produce an increase in the value of a project with flexibility?
a) It increases the present value of the cash flows.
b) A higher interest rate increases the time value of the deferral of an investment.
c) There is not any set relationship between interest rates and the value of flexibility.
d) Higher interest rates are more stable than lower rates and produce more stable cash flows.
10. The option to abandon (or sell) a project, such as the right to abandon a coal mine, is most
similar to:
a) A swap contract.
b) A put option on a stock.
c) A call option on a stock.
d) A futures contract on a bond.
11. The option to defer investment, such as the ability of a leaseholder of an undeveloped oil
reserve to defer development and investment until oil prices have elevated the value of the
reserves above their development costs, is most similar to:
a) A swap contract.
b) A put option on a stock.
c) A call option on a stock.
d) A futures contract on a bond.
12. The option to increase scope, such as A hotel designed so that the owner can easily diversify
beyond lodging services, such as by adding conference facilities, is most similar to:
a) A swap contract.
b) A put option on a stock.
c) A call option on a stock.
d) A futures contract on a bond.
13. Which of the following are components of financial options and also map to value from
flexibility?
I. Time to expiration.
II. Forgone cash flows.
III. Uncertainty about the value of the underlying asset.
IV. Forward rates.
a) I and II only.
b) I and III only.
c) I, II, and III only.
d) I, II, III, and IV.
14. Managing flexibility depends on manager’s ability to recognize, structure, and manage
opportunities to create value from operating and strategic flexibility.
15. Construction of a replicating portfolio can be used to value an option embedded in an
investment opportunity.
16. Valuation based on decision tree analysis (DTA) should discount both components of the
contingent cash flows using the risk-free rate.
17. Which of the following are true with respect to using real-option valuation (ROV) versus
decision tree analysis (DTA)?
I. ROV is recommended when the future cash flows are closely linked to traded commodities.
II. DTA is recommended when the future cash flows are closely linked to traded currencies.
III. DTA is recommended when most of the underlying risk can be diversified away.
IV. DTA is recommended when only rough estimates are available for required inputs such as
the underlying asset value and variance.
a) I and II only.
b) II and III only.
c) I, III, and IV only.
d) I, II, III, and IV.
18. How can managers decide which type of contingent valuation works best based on the
types of risk they face?
19. Phased investments, such as a factory that can be built in stages where each stage is
contingent on those that precede it and where, at each decision point, management can
continue the project by investing additional funds (an exercise price) or abandon it for some
estimated value, would best be categorized as:
a) A swap.
b) A follow-on option.
c) A switching option.
d) A case where option theory cannot apply.
20. Which of the following most accurately lists the steps in the four-step process for valuing
flexibility in the correct order?
a) 1. Estimate NPV without flexibility. 2. Model uncertainty in event tree. 3. Model flexibility in
decision tree. 4. Estimate contingent NPV.
b) 1. Estimate NPV without flexibility. 2. Model flexibility in decision tree. 3. Model uncertainty
in event tree. 4. Estimate contingent NPV.
c) 1. Model uncertainty using real-option valuation. 2. Model flexibility using decision tree
analysis. 3. Estimate NPV without flexibility. 4. Arithmetically weight the three results to
estimate contingent NPV.
d) 1. Model uncertainty using real-option valuation. 2. Model flexibility using decision tree
analysis. 3. Estimate NPV without flexibility. 4. Geometrically weight the three results to
estimate contingent NPV.
21. A project has a 50/50 chance of generating either a positive cash flow of $1 per year forever
or a zero cash flow. The discount rate is 5 percent. If the initial cost is $10, what is the NPV with
the option to stop after the first year?
a) –$10
b) $0
c) $10
d) $20
22. In the event tree used in the binomial approach to option valuation, at each node the value
either increases or decreases by the proportion u or d, respectively. If the annualized volatility
of the underlying asset’s value is 10 percent per year and the horizon is six months, what are
the up-movement u and down-movement d values?
a) 1.0488 and 0.9534
b) 1.0513 and 0.9511
c) 1.0733 and 0.9317
d) 1.2505 and 0.8000