Chapter 13: Real Options True/False Page 475
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lines.
Multiple Choice: True/False
1
. 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
2
. 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
3
. Real options are options to buy real assets, especially stocks, rather
than interest-bearing assets, like bonds.
a. True
b. False
4
. 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
5
. 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
Page 476 True/False Chapter 13: Real Options
6
. 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
7
. 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
8
. 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
9
. 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
10
. 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
11
. For planning purposes, managers must forecast the total capital budget
because the amount of capital raised affects the WACC.
a. True
b. False
12
. 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 True/False Page 477
13
. 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
14
. 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
15
. 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
16
. 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
17
. 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
18
. 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
Page 478 Conceptual M/C Chapter 13: Real Options
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
. 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
Multiple Choice: Conceptual
21
. 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.
22
. 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.
23
. 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.
Chapter 13: Real Options Conceptual M/C Page 479
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.
24
. 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.
25
. 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.
26
. 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.
Page 480 Conceptual M/C Chapter 13: Real Options
e. A decrease in the probability that a competitor will enter the
market of the project in question.
Chapter 13: Real Options Conceptual M/C Page 481
27
. 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.
28
. 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.
29
. 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.
Page 482 Conceptual M/C Chapter 13: Real Options
30
. 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.
31
. 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 M/C Problems Page 483
Multiple Choice: Problems
32
. 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
33
. 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. $4,106
Page 484 M/C Problems Chapter 13: Real Options
34
. 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
35
. 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 M/C Problems Page 485
36
. 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
e. $155
37
. 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 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
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
Page 486 M/C Problems Chapter 13: Real Options
d. $2,471
e. $2,718
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 M/C Problems Page 487
Multiple Part:
Problems 40 and 41 must be kept together. 40 can be used alone, but use 41 ONLY if 40 is
also used.
40
. 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 look bad 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 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 a $25,000 cash
inflow at t = 3, and a 50% probability of finding less oil and then
only receiving a $10,000 inflow.
Since the project is considered to be quite risky, a 20.0% cost
of capital is used. 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
41
. In the previous problem you were asked to find the expected NPV of a
project TWI is considering. Use the same data to calculate the
project’s coefficient of variation. (Hint: Use the expected NPV as
found in Problem 40.)
a. 5.87
b. 6.52
c. 7.25
d. 7.97
e. 8.77
Page 488 Answers Chapter 13: Real Options