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CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
Multiple Part:
The following 2 problems must be kept together. The first problem can be used alone, but use the second problem ONLY
if the first problem is also used.
Exhibit 13.1
Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties, then selling the successful ones
to major oil companies. It is now considering a new potential field, and its geologists have developed the following data,
shown in thousands of dollars.
* t = 0 A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company
should commence drilling operations or make no further investment and abandon the project. There is an 80% probability
that the feasibility study would indicate that an exploratory well should be drilled. There is a 20% probability that no
further work would be done.
* t = 1 If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill an exploratory
well. The best estimate is that there is a 60% probability that the exploratory well would indicate good potential and thus
that further work would be done, and a 40% probability that the outlook would be poor and the project would be
abandoned.
* t = 2 If the exploratory well tests positive, the firm would go ahead and spend $10,000 to obtain an accurate estimate
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
of the amount of oil in the field at t = 2.
* t = 3 If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving $25,000
cash inflow at t = 3, and a 50% probability of finding less oil and then receiving only a $10,000 inflow.
* Since the project is considered to be quite risky, a 20.00% cost of capital is used.
29. Refer to Exhibit 13.1. What is the project's expected NPV, in thousands of dollars?
a.
$336.15
b.
$373.50
c.
$415.00
d.
$461.11
e.
$507.22
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
30. Refer to Exhibit 13.1 and to previous problem. Calculate the project's coefficient of variation. (Hint: Use the expected
NPV as found in previous problem.)
a.
5.87
b.
6.52
c.
7.25
d.
7.97
e.
8.77
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
31. Chrustuba Inc. is evaluating a new project that would cost $9 million at t = 0. There is a 50% chance that the project
would be highly successful and generate annual after-tax cash flows of $6 million during Years 1, 2, and 3. However,
there is a 50% chance that it would be less successful and would generate only $1 million for each of the 3 years. If the
project is highly successful, it would open the door for another investment of $10 million at the end of Year 2, and this
new investment could be sold for $20 million at the end of Year 3. Assuming a WACC of 10.0%, what is the project's
expected NPV (in thousands) after taking into account this growth option?
a.
$2,776
b.
$3,085
c.
$3,393
d.
$3,733
e.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
32. Which one of the following statements best describes the most likely impact that a profitable abandonment option
would have on a project's expected cash flow and risk?
a.
No impact on the PV of expected cash flows, but risk will increase.
b.
The PV of expected cash flows increases and risk decreases.
c.
The PV of expected cash flows increases and risk increases.
d.
The PV of expected cash flows decreases and risk decreases.
e.
The PV of expected cash flows decreases and risk increases.
33. Carlson Inc. is evaluating a project in India that would require a $6.2 million investment today (t = 0). The after-tax
cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in
which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the tax
doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12.0%. The firm would
have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.35
million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is abandoned, the
company would receive no further cash inflows from it. What is the value (in thousands) of this abandonment option?
a.
$104
b.
$115
c.
$128
d.
$141
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
e.
$155
34. High Roller Properties is considering building a new casino at a cost of $10 million at t = 0. The after-tax cash flows
the casino generates will depend on whether the state imposes a new income tax, and there is a 50-50 chance the tax will
pass. If it passes, after-tax cash flows will be $1.875 million per year for the next 5 years. If it doesn't pass, the after-tax
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
cash flows will be $3.75 million per year for the next 5 years. The project's WACC is 11.0%. If the tax is passed, the firm
will have the option to abandon the project 1 year from now, in which case the property could be sold to net $6.5 million
after tax at t = 1. What is the value (in thousands) of this abandonment option?
a.
$202
b.
$224
c.
$249
d.
$277
e.
$308
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
35. Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project
has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be
negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following
statements best describes the issues that the firm faces when considering this investment timing option?
a.
The investment timing option would not affect the cash flows and therefore would have no impact on the
project's risk.
b.
The more uncertainty about the future cash flows, the more logical it is to go ahead with this project today.
c.
Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if
the firm chooses to wait a year.
d.
Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in
that NPV.
e.
Waiting would probably reduce the project's risk.
36. Lindley Corp. is considering a new product that would require an investment of $10 million now, at t = 0. If the new
product is well received, then the project would produce after-tax cash flows of $5 million at the end of each of the next 3
years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $2 million per year. There
is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to
determine if demand is likely to be strong or weak. The project's cost and expected annual cash flows would be the same
whether the project is delayed or not. The project's WACC is 10.0%. What is the value (in thousands) of the project after
considering the investment timing option?
a.
$ 726
b.
$ 807
c.
$ 896
d.
$ 996
e.
$1,106
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
37. Winters Corp. is considering a new product that would require an investment of $20 million now, at t = 0. If the new
product is well received, then the project would produce after-tax cash flows of $10 million at the end of each of the next
3 years (t = 1, 2, 3), but if the market did not like the product, then the cash flows would be only $4 million per year.
There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test
to determine if demand is likely to be strong or weak, but it would have to incur costs to obtain this timing option. The
project's cost and expected annual cash flows would be the same whether the project is delayed or not. The project's
WACC is 11.0%. What is the value (in thousands) of the option to delay the project?
a.
$1,311
b.
$1,457
c.
$1,619
d.
$1,799
e.
$1,999
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
38. Games Unlimited Inc. is considering a new game that would require an investment of $20.0 million. If the new game
is well received, then the project would produce cash flows of $9.5 million a year for 3 years. However, if the market does
not like the new game, then the cash flows would be only $6.0 million per year. There is a 50% probability of both good
and bad market conditions. The firm could delay the project for a year while it conducts a test to determine if demand
would be strong or weak. The project's cost and expected annual cash flows would be the same whether the project is
delayed or not. If the WACC is 9.0%, what is the value (in thousands) of the investment timing option?
a.
$1,857
b.
$2,042
c.
$2,246
d.
$2,471
e.
$2,718
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
39. Norris Production Company (NPC) is considering a project that has an up-front cost at t = 0 of $2,500. (All dollars in
this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's
product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC's product will
have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a
75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $750 at the
end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor's product will be approved, in
which case the expected cash flows will be only $50 at the end of each of the next seven years (t = 1 to 7). NPC will know
for sure one year from today whether the competitor's product has been approved.
NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision. If it
waits a year, the project's up-front cost at t = 1 will remain at $2,500, the subsequent cash flows will remain at $750 per
year if the competitor's product is rejected and $50 per year if the alternative product is approved. However, if NPC
decides to wait, the subsequent cash flows will be received only for six years (t = 2 ... 7). In addition, once NPC knows the
outcome of the FDA's decision, it will not take on the project if its NPV is negative.
This is a risky project, so a WACC of 16.0% is to be used. If NPC chooses to wait a year before proceeding, what is the
value of the timing option today?
a.
$124.22
b.
$138.02
c.
$153.36
d.
$170.40
e.
$187.44
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
40. Which one of the following is an example of a "flexibility" option?
a.
A company has an option to invest in a project today or to wait for a year before making the commitment.
b.
A company has an option to close down an operation if it turns out to be unprofitable.
c.
A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at
a later date if conditions change.
d.
A company invests in a project today to gain knowledge that may enable it to expand into different markets at
a later date.
e.
A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings
feeling less tired than if he had to fly a commercial airline.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
41. Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its
assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%,
and high-risk projects at 12%. The company is considering the following projects:
Project
Risk
Expected Return
A
High
15%
B
Average
12%
C
High
11%
D
Low
9%
E
Low
6%
Which set of projects would maximize shareholder wealth?
a.
A and B.
b.
A, B, and C.
c.
A, B, and D.
d.
A, B, C, and D.
e.
A, B, C, D, and E.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
