Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1)
Which of the following is not a real option?
1)
A)
An expansion option
B)
An abandonment option
C)
An investment timing option
D)
A stock option
Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test
marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team
believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the
new mountain bike. If the test–marketing phase is successful, then Kinston Industries will invest $3 million in year one to
build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the
test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash
flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and
sell the prototype mountain bike to an overseas competitor for $300,000. Kinston‘s cost of capital is 10%.
2)
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go
ahead and build their manufacturing plant immediately. Assuming that the probability of high or
low demand is still 50%, the NPV of the Kinston Industries Mountain Bike Project is closest to:
2)
A)
$1,000,000
B)
$90,000
C)
$0
D)
–$45,000
Use the table for the question(s) below.
Consider the following mutually exclusive projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
A–79 20 25 30 35 40 N/A N/A 15%
B–80 25 25 25 25 25 25 25 15%
3)
The equivalent annual benefit of project B is closest to:
3)
A)
$3.40
B)
$5.05
C)
$5.75
D)
3.45
4)
Which of the following statements is false?
4)
A)
In practice, correctly modeling the sources of uncertainty and the appropriate dynamic
decisions usually requires an extensive amount of time and financial expertise.
B)
Some firms use the following rule of thumb: Invest whenever the profitability index is below
a specified level.
C)
Instead of raising the bar on the NPV, the hurdle rate rule raises the discount rate.
D)
The profitability index rule of thumb raises the bar on the NPV to take into account the option
to wait.
Explanation:
Explanation:
5)
Which of the following statements is false?
5)
A)
When the source of uncertainty that creates a motive to wait is interest rate uncertainty, the
hurdle rate is relatively easy to calculate.
B)
When the investment cannot be delayed, the optimal rule is to invest whenever the
profitability index is greater than zero.
C)
It is often better to wait too long (use a profitability index criterion that is too high) than to
invest too soon (use a profitability index criterion that is too low).
D)
When there is an option to delay, a good rule of thumb is to invest only when the profitability
index is at least 1.
6)
Which of the following statements is false?
6)
A)
The equivalent annual benefit method ignores the value of any real options because it
assumes that the projects will always be replaced at their original terms.
B)
The equivalent annual benefit method accounts for the difference in project lengths by
calculating the constant payment over the life of the project that is equivalent to receiving the
NPV today and then selecting the project with the higher equivalent annual benefit.
C)
Traditionally, managers have used the equivalent annual benefit method to choose between
projects of different lives.
D)
If the future costs (or benefits) are certain with mutually exclusive projects, then we must use
a real options approach to determine the correct decision.
Use the information for the question(s) below.
You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a
decision on a long–term government contract, your revenues will either increase by 20% or decrease by 25%, with equal
probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell
the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
7)
Given the embedded option to sell the plant, the value of your plant will be closest to:
7)
A)
$8.0 million
B)
$6.5 million
C)
$4.0 million
D)
$5.0 million
Use the table for the question(s) below.
Consider the following mutually exclusive projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
A–79 20 25 30 35 40 N/A N/A 15%
B–80 25 25 25 25 25 25 25 15%
8)
The NPV of project A is closest to:
8)
A)
$18.10
B)
$16.90
C)
$21.70
D)
$24.00
Use the information for the question(s) below.
You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a
decision on a long–term government contract, your revenues will either increase by 20% or decrease by 25%, with equal
probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell
the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
9)
Assume that you are not able to sell the plant, but you are able to shut down the plant at no cost at
any time. Given the embedded option to abandon production the value of your plant will be
closest to:
9)
A)
$4.0 million
B)
$5.0 million
C)
$6.5 million
D)
$8.0 million
10)
Which of the following statements is false?
10)
A)
When a firm faces the same uncertainty for most of its investment decisions, using a single
profitability index criterion for all projects can provide a useful rule of thumb to account for
cash flow uncertainty.
B)
While using a hurdle rate rule for deciding when to invest might be a cost–effective way to
make investment decisions, it is important to remember that this rule does not provide an
accurate measure of value.
C)
When the cash flows are constant and perpetual, and the reason to wait derives solely from
interest rate uncertainty, the hurdle rate rule of thumb is always exact. However, when these
conditions are not satisfied, the rule of thumb merely approximates the correct decision.
D)
The hurdle rate rule for projects with the option to delay uses a lower discount rate than the
cost of capital to compute the NPV, but then applies the regular NPV rule: Invest whenever
the NPV calculated using this lower discount rate is positive.
11)
Which of the following statements is false?
11)
A)
By delaying an investment, we can base our decision on additional information.
B)
In the real option context, the dividends correspond to any value from the investment that we
give up by waiting.
C)
Given the option to wait, an investment that currently has a negative NPV can have a positive
value.
D)
If there is a lot of uncertainty, the benefit of waiting is diminished.
Use the table for the question(s) below.
Consider the following mutually exclusive projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
A–79 20 25 30 35 40 N/A N/A 15%
B–80 25 25 25 25 25 25 25 15%
12)
The NPV of project B is closest to:
12)
A)
$21.70
B)
$24.00
C)
$16.90
D)
$18.10
Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test
marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team
believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the
new mountain bike. If the test–marketing phase is successful, then Kinston Industries will invest $3 million in year one to
build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the
test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash
flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and
sell the prototype mountain bike to an overseas competitor for $300,000. Kinston‘s cost of capital is 10%.
13)
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000, the
NPV of the Kinston Industries Mountain Bike Project is closest to:
13)
A)
–$45,000
B)
$455,000
C)
$90,000
D)
$590,000
Use the information for the question(s) below.
You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a
decision on a long–term government contract, your revenues will either increase by 20% or decrease by 25%, with equal
probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell
the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
14)
If you are awarded the government contract and your sales increase by 20%, then the value of your
plant will be closest to:
14)
A)
$5 million
B)
$0
C)
$8 million
D)
$4 million
15)
Which of the following statements is false?
15)
A)
When you do not have the option to wait, it is optimal to invest in any positive–NPV project.
B)
You invest today only when the NPV of investing today exceeds the value of the option of
waiting, which from option pricing theory we know to be always positive.
C)
One way to see why you sometimes choose not to invest in a positive–NPV project is to think
about the decision of when to invest as a choice between two mutually exclusive projects: (1)
invest today or (2) wait.
D)
When you have the option of deciding when to invest, it is usually optimal to invest only
when the NPV is positive but close to zero.
Use the table for the question(s) below.
Consider the following mutually exclusive projects:
Project
Year 0
C/F
Year 1
C/F
Year 2
C/F
Year 3
C/F
Year 4
C/F
Year 5
C/F
Year 6
C/F
Year 7
C/F
Discount
Rate
A–79 20 25 30 35 40 N/A N/A 15%
B–80 25 25 25 25 25 25 25 15%
16)
The equivalent annual benefit of project A is closest to:
16)
A)
$3.40
B)
$21.70
C)
$24.00
D)
$5.05
17)
Which of the following statements is false?
17)
A)
An alternative to using the Black–Scholes formula is to compute the value of growth options
using risk neutral probabilities.
B)
Future growth options are not only important to firm value, but can also be important in the
value of an individual project.
C)
Out–of–the–money calls are riskier than in–the–money calls, and because most growth
options are likely to be out–of–the–money, the growth component of firm value is likely to be
riskier than the ongoing assets of the firm.
D)
While the Black–Scholes formula values American options, most growth options cannot be
exercised at any time.
18)
Which of the following statements is false?
18)
A)
It is always better to wait to invest unless there is a cost to doing so.
B)
The smaller the cost of waiting, the less attractive the option to delay becomes.
C)
The option to wait is most valuable when there is a great deal of uncertainty regarding what
the value of the investment will be in the future.
D)
Aside from the current NPV of the investment, other factors affect the value of an investment
and the decision to wait.
19)
Which of the following statements is false?
19)
A)
A decision tree is a graphical representation of future decisions and uncertainty resolution.
B)
Decision nodes are nodes in which uncertainty is involved that is out of the control of the
decision maker.
C)
Most investment projects allow for the possibility of reevaluating the decision to invest at a
later point in time.
D)
With binomial trees the uncertainty is not under the control of the decision maker.
While the Black–Scholes formula values European options, most growth options
20)
Which of the following statements is false?
20)
A)
It is tempting to use the Black–Scholes formula to value future growth options, but often there
are good reasons why this formula might not price these options correctly.
B)
When a firm has a real option to invest in the future it is known as a growth option.
C)
Future growth opportunities can be thought of as a collection of real put options on potential
projects.
D)
Because growth options have value, they contribute to the value of any firm that has future
possible investment opportunities.
21)
Which of the following statements is false?
21)
A)
An abandonment option is the option to walk away.
B)
Abandonment options can add value to a project because a firm can drop a project if it turns
out to be unsuccessful.
C)
Corporate bonds often contain embedded abandonment options: The issuing firm sometimes
has the option to convert the bond–that is, to repay it.
D)
An important abandonment option that most people encounter at some point in their lives is
the option to abandon their mortgage.
Use the information for the question(s) below.
You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a
decision on a long–term government contract, your revenues will either increase by 20% or decrease by 25%, with equal
probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell
the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
22)
If you are not awarded the government contract and your sales decrease by 25%, then the value of
your plant will be closest to:
22)
A)
$8 million
B)
–$1 million
C)
$5 million
D)
$0
23)
Which of the following statements is false?
23)
A)
In particular, because real options allow a decision maker to choose the most attractive
alternative after new information has been learned, the presence of real options adds value to
an investment opportunity.
B)
We can compute the value of the real option by comparing the expected profit without the
real option to the value with the option.
C)
A key distinction between a real option and a financial option is that real options, and the
underlying assets on which they are based, are often traded in competitive markets.
D)
To make an investment decision correctly, the value of embedded real options must be
included in the decision–making process.
Use the information for the question(s) below.
You own a small manufacturing plant that currently generates revenues of $2 million per year. Next year, based upon a
decision on a long–term government contract, your revenues will either increase by 20% or decrease by 25%, with equal
probability, and stay at that level as long as you operate the plant. Other costs run $1.6 million dollars per year. You can sell
the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
24)
Assume that it will cost you $1 million to shut down the plant, but you are able to sell the plant for
$5 million at any time. The value of the option to sell the plant will be closest to:
24)
A)
$6.0 million
B)
$3.0 million
C)
$0.5 million
D)
$5.0 million