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CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
1. Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no
reason to consider real options separately from the NPV analysis.
a.
True
b.
False
2. Real options are most valuable when the underlying source of risk--such as uncertainty about unit sales, or the sales
price, or input costs--is very low.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
3. Real options can affect the size of a project's expected NPV but not project's risk as measured by the standard deviation
or coefficient of variation of the NPV.
a.
True
b.
False
4. Real options exist whenever managers have the opportunity, after a project has been implemented, to make operating
changes in response to changed conditions that modify the project's cash flows.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
5. Traditional discounted cash flow (DCF) analysis--where a project's cash flows are estimated and then discounted to
obtain an expected NPV--has been the cornerstone of capital budgeting since the 1950s. However, in recent years, it has
been demonstrated that DCF techniques do not always lead to proper capital budgeting decisions due to the existence of
real options.
a.
True
b.
False
6. Real options are options to buy real assets, especially stocks, rather than interest-bearing assets, like bonds.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
7. The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options,
(3) timing options, and (4) abandonment options.
a.
True
b.
False
8. The following are all examples of real options that are discussed in the text: (1) protection options, (2) flexibility
options, (3) timing options, and (4) abandonment options.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
9. The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility
options, (3) timing options, and (4) abandonment options.
a.
True
b.
False
10. The option to abandon a project is a real option, but a call option on a stock is not a real option.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
11. The true expected value of a project with a growth option is the expected NPV of the project (including the value of
the option) less the cost of obtaining that option.
a.
True
b.
False
12. It is not possible for abandonment options to decrease a project's risk as measured by the project's coefficient of
variation.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
13. Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be
undertaken now or never. However, in practice, companies sometimes have a third choice--delay the decision until later,
when more information will be available.
a.
True
b.
False
14. Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be
undertaken now or never. However, in practice, companies sometimes have a third choice--delay the decision until later,
when more information will be available. Because the analysis extends out at least one additional year from the original
analysis, it is unlikely that the firm would ever delay a project--particularly given the loss of the "first mover advantage."
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
15. For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the
WACC.
a.
True
b.
False
16. The optimal capital budget is the size of the capital budget where the rate of return on the marginal project is equal to
the marginal cost of capital.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
17. Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how
many good projects it has.
a.
True
b.
False
18. If a firm practices capital rationing, this means that it is accepting fewer projects than would be theoretically optimal;
hence, it is not maximizing its theoretical value.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
19. A firm's optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive
projects that have the highest positive NPVs.
a.
True
b.
False
20. An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with
those predicted by the project's sponsors and explaining why any differences occurred.
a.
True
b.
False
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
21. Which one of the following will NOT increase the value of a real option?
a.
Lengthening the time during which a real option must be exercised.
b.
An increase in the volatility of the underlying source of risk.
c.
An increase in the risk-free rate.
d.
An increase in the cost of obtaining the real option.
e.
A decrease in the probability that a competitor will enter the market of the project in question.
22. Which one of the following statements is most CORRECT?
a.
Real options change the size, but not the risk, of projects' expected NPVs.
b.
Real options change the risk, but not the size, of projects' expected NPVs.
c.
Real options can reduce the cost of capital that should be used to discount a project's expected cash flows.
d.
Very few projects actually have real options. They are theoretically interesting but of little practical
importance.
e.
Real options are more valuable when there is very little uncertainty about the true values of future sales and
costs.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
23. Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it
considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it
evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing
option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements
is CORRECT?
a.
The abandonment option tends to reduce a project's NPV.
b.
The abandonment option tends to reduce a project's risk.
c.
If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more
information before proceeding with a proposed project.
d.
A project can either have an abandonment option or an investment timing option, but never both.
e.
Investment timing options always increase the value of a project.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
24. Which of the following statements is CORRECT?
a.
In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before
making an investment.
b.
In general, the greater the strategic advantages of being the first competitor to enter a given market, the more
attractive it probably is to wait before making an investment.
c.
In general, the higher the discount rate, the more attractive it probably is to wait before making an investment.
d.
In general, investment timing options are more valuable than abandonment options.
e.
In general, abandonment options are rarely seen in the real world.
25. Weisbach Electronics is considering investing in India. Which of the following factors would make the company less
likely to proceed with the investment?
a.
The company would have the option to withdraw from the investment after 2 years if it turns out to be
unprofitable.
b.
The investment would increase the odds of the company being able to subsequently make a successful entry
into China.
c.
The investment would preclude the company from being able to make a profitable investment in China.
d.
Competitors are considering similar investments in India, and the firm can discourage them from trying by
entering now.
e.
The new plant could be easily retrofitted to manufacture many of the firm's other products.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
26. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating
projects' sales and costs. However, it never considers any real options that might be associated with projects. Which of the
following statements is most likely to describe its situation?
a.
Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options
are taken into account.
b.
Its estimated capital budget is probably too large due to its failure to consider abandonment and growth
options.
c.
Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large,
but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is
unclear what impact the failure to consider real options has on the overall capital budget.
d.
Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small,
but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is
unclear what impact not considering real options has on the overall capital budget.
e.
Real options should not have any effect on the size of the optimal capital budget.
CHAPTER 13—REAL OPTIONS AND OTHER TOPICS IN CAPITAL BUDGETING
27. Which one of the following is NOT a real option?
a.
The option to expand production if the product is successful.
b.
The option to buy shares of stock if its price is expected to increase.
c.
The option to expand into a new geographic region.
d.
The option to abandon a project if cash flows turn out to be lower than expected.
e.
The option to switch the type of fuel used in an industrial furnace to lower the cost of production.
28. Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue
projections shown below. One of Tutor's larger competitors, Online Professor (OP), is expected to do one of two things in
Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's
program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35%
probability that its program will be purchased for $6 million and a 65% probability that it won't be bought, and thus the
program will simply be closed down with no salvage value. What is the estimated net present value of the project (in
thousands) at a WACC = 10%, giving consideration to the potential future purchase?
WACC =
10.0%
0
1
2
3
4
5
Original project:
−$3,000
$500
$500
$500
$500
$500
Future
Prob.
Buys
35%
$6,000
Doesn't buy
65%
$0
a.
$161.46
b.
$179.40
c.
$199.33
d.
$219.26
e.
$241.19
