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Exam 14: Real Options

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Question 1

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For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC.

A) True
B) False

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Question 2

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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

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Question 3

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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?

Texas Wildcatters Inc. (TWI) 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?

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."

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?

Langston Labs has an overall (composite) Which set of projects would maximize shareholder wealth?

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.

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.

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.

Which one of the following is NOT a real option?

Real options are options to buy real assets, especially stocks, rather than interest-bearing assets, like bonds.

Which one of the following will NOT increase the value of a real option?

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.

Weisbach Electronics is considering investing in India. Which of the following factors would make the company less likely to proceed with the investment?

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?

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?

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?

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.

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?