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Exam 13: Real Options and Other Topics in Capital Budgeting

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Question 21

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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

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Question 22

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

A) True
B) False

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Question 23

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Which one of the following is an example of a "flexibility" option?

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 $7.0 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 = 9.0%,giving consideration to the potential future purchase? Do not round intermediate calculations. $\mathrm{WACC}=\quad 9.0 \%$ $\begin{array}{ll}&0&1&2&3&4&5\\\hline\text { Original project: }&-\$3,500&\$600&\$600&\$600&\$600&\$600\end{array}$ $\begin{array}{ll}\text { Future} &\text { Prob. }\\\text { Buys } & 35 \% &&\$7,000\\\text { Doesn't buy } & 65 \%&&\$0\end{array}$

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.

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 $350 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 $1,200 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 $8,000 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 $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then receiving only a $8,000 inflow. * Since the project is considered to be quite risky, a 18.00% cost of capital is used. -Refer to Exhibit 13.1.What is the project's expected NPV,in thousands of dollars? ?

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

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.

Carlson Inc.is evaluating a project in India that would require a $5.8 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 $1,800,000 for 5 years.The project has a WACC of 10.4%.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 $4.45 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? Do not round intermediate calculations.

It is not possible for abandonment options to decrease a project's risk as measured by the project's coefficient of variation.

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.

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?

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.

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.

Lindley Corp.is considering a new product that would require an investment of $10.5 million now,at t = 0.If the new product is well received,then the project would produce after-tax cash flows of $5.3 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 $2.6 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 9.2%.What is the value (in thousands) of the project after considering the investment timing option? Do not round intermediate calculations. ?

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.

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.

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

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."

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.