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25)
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. The value of the option to abandon production will be closest to:
25)
A)
$1.0 million
B)
-$1.0 million
C)
$0.5 million
D)
$3.0 million
26)
Which of the following statements is false?
26)
A)
More often than not, there is an opportunity cost of abandoning a project: If you shut down
the project and later decide to start it up again, you have to pay the costs of restarting the
project.
B)
A popular option gives holders of the bond the option to convert the bond into equity. These
kinds of bonds are termed callable bonds.
C)
Often, the decision to abandon a project entails costs, which may be either positive or
negative.
D)
Mortgage interest rates are higher than Treasury rates because mortgages have an
abandonment option that Treasuries do not have: You can prepay your mortgage at any time,
while the U.S. government can repay its debt only according to the schedule outlined in the
bond contract.
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%.
27)
Assuming that Kinston has the ability to sell the prototype in year one for $300,000, the NPV of the
Kinston Industries Mountain Bike Project is closest to:
27)
A)
$455,000
B)
$90,000
C)
-$45,000
D)
$590,000
ESSAY. Write your answer in the space provided or on a separate sheet of paper.
28)
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build
their manufacturing plant immediately. Further assume that the probability of high or low demand is still 50%.
Draw a decision tree that details Kinston Industries Mountain Bike project if Kinston goes ahead and builds the
plant immediately.
29)
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build
their manufacturing plant immediately and that the probability of high or low demand would still be 50%.
What is the value of the the option to do pilot production and test marketing?
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%
30)
Using the equivalent annual benefit method, which project would you select and why?
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%.
31)
Assuming that Kinston has the ability to sell the prototype in year one for $300,000, draw a decision tree
detailing the Kinston Industries Mountain Bike Project.
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%.
32)
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.
Draw a decision tree detailing this problem.
33)
Assuming you are able to see the plant, draw a decision tree detailing this problem.
34)
Luther Industries is considering launching a new toy just in time for the Christmas season. They estimate that if
Luther launches the new toy this year it will have an NPV of $25 million. Luther has the option to wait one year
until the next Christmas season to launch the toy, however, the demand next year will depend upon what new
toys Luther's competitors introduce and therefore greater uncertainty about next years demand. Launching the
new today will involve a total capital expenditure of $100 million. If the risk-free rate is 5%, N(d1) is .62 and
N(d2) is .65, then what is the value of the option to wait until next year to launch the new toy?
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%.
35)
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000, draw a decision
tree detailing the Kinston Industries Mountain Bike Project.
36)
Describe the two factors that affect the value of an investment timing option?
Answer Key
Testname: C22
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Answer Key
Testname: C22
Answer Key
Testname: C22
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Answer Key
Testname: C22
