Deck 22: Real Options

Question 1

Permanently rejecting an investment today might not be a good choice because:
I.the size of the firm will decline;
II.there are always errors in the estimation of NPVs;
III.the project's real option value is negative;
IV.the company is forgoing the option to make the investment in the future if economic and industry conditions change for the better

A)I only
B)II only
C)I,II,and III only
D)IV only

Answer 1

IV only

Question 2

Which of the following are examples of applications of real options analysis?
I.a strategic investment in the computer business;
II.the valuation of an aircraft purchase option;
III.the option to develop commercial real estate;
IV.the decision to mothball an oil tanker

A)I only
B)I and II only
C)I,II,and III only
D)I,II,III,and IV

Answer 2

I,II,III,and IV

Question 3

The NPV of a new video game,Dexa 1,is -1.5M after discounting all expected cash flows.However,if high demand in the market evolves,Dexa 2 is a possible follow-on opportunity in two years.In two years it will cost 10M to start Dexa 2,which will produce 9M of cash flow in year 2.N(d₁)= 0.5785 and N(d₂)= 0.1755.The annual interest rate is 11% and equals the risk-free rate.What is the Dexa 1 APV?

A)$1.95 M
B)$1.30 M
C)$2.28 M
D)$2.80 M

Answer 3

$1.30 M

Question 4

Suppose that the oil price is uncertain and can be $60/bbl.or $30/bbl.next year with equal probability.Then the value of the option to postpone the project by one year equals:

A)+34 million
B)+25 million
C)+59 million
D)-13 million

Question 5

A firm has a two-year real option to invest in a project that has a present value of $400 million with an exercise price (in year 2)of $600 million.Calculate the value of the option given that N(d₁)= 0.6 and N(d₂)= 0.4.Assume that the risk-free interest rate is 6% per year.

A)$26.4 million
B)zero
C)$239.59 million
D)$13.58 million

Question 6

Which of the following are examples of real options?
I.the option to expand if an investment project succeeds;
II.the option to wait (and learn)before investing;
III.the option to shrink or abandon a project;
IV.the option to vary the mix of output or the firm's production methods

A)I only
B)I and II only
C)I,II,and III only
D)I,II,III,and IV

Question 7

Which of the following statements about the option to build flexibility into production facilities is true?

A)Typically,production flexibility is more expensive.
B)One should consider the NPV of alternate production configurations.
C)Production flexibility may be valuable by enabling the firm to choose the inputs with the lowest available costs.
D)All of the options are true.

Question 8

The discounted cash-flow (DCF)approach should be:

A)augmented by real options analysis even if there are no imbedded options.
B)augmented by added analysis if a decision has significant imbedded options.
C)jettisoned if there are any embedded options.
D)computed carefully to identify the options.

Question 9

Calculate the NPV from investing today.

A)+40 million
B)+75 million
C)+25 million
D)+150 million

Question 10

The opportunity to defer investing to a later date may have value because:
I.the cost of capital may increase in the near future;
II.uncertainty may be increased in the future;
III.the project has positive,short-term cash flows;
IV.market conditions may change and increase the NPV of the project

A)I only
B)I and II only
C)III only
D)IV only

Question 11

Managers who hold real options should view:

A)themselves as passive onlookers with no decision making opportunities.
B)real options as tools for reducing the total risk of the firm through diversification.
C)real options as opportunities to alter management decisions in the future.
D)themselves as agents who are looking for higher compensation.

Question 12

A project is worth $15 million today without an abandonment option.Suppose the value of the project is either $20 million one year from today (if product demand is high)or $10 million (if product demand is low).It is possible to sell off the project for $13 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.

A)$1.21 million
B)$2.86 million
C)$1.90 million
D)$1.64 million

Question 13

A firm has a three-year real option to invest in a project that has a present value of $500 million with an exercise price (in year 3)of $800 million.Calculate the value of the option given that N(d₁)= 0.3 and N(d₂)= 0.15.Assume that the risk-free interest rate is 6% per year.

A)$30.00 million
B)$49.25 million
C)zero
D)$7.08 million

Question 14

Suppose that the oil price is uncertain and can be either $60/bbl.or $30/bbl.next year with equal probability.Calculate the expected NPV of the project if it is postponed by one year.

A)+50 million
B)-25 million
C)+59 million
D)+47 million

Question 15

The following are examples of expansion options:
I.A mining company acquires mineral rights to land that is not worth developing today but could be profitable if ore prices increase.
II.A film studio acquires the rights to produce a film based on the novel.
III.A real estate developer acquires a parcel of land that could be turned into a shopping mall.
IV.A pharmaceutical company purchases a patent to market a new drug.

A)I only
B)I and II only
C)I,II,and III only
D)I,II,III,and IV

Question 16

Which of the following scenarios fails to describe a possible real option embedded in a project analysis?

A)A truck fleet outfitted with engines capable of running on five various types of fuel
B)A patent developed on a new process of slicing bread
C)A new product line started with future follow-on investments available
D)The articles of incorporation amended to allow for stock splits and reverse stock splits

Question 17

A project is worth $12 million today without an abandonment option.Suppose the value of the project is either $18 million one year from today (if product demand is high)or $8 million (if product demand is low).It is possible to sell off the project for $10 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.

A)$1.03 million
B)$0.88 million
C)$1.90 million
D)$5.14 million

Question 18

An abandonment option,in effect,

A)limits the flexibility of management's decision-making.
B)limits the downside risk of an investment project.
C)limits the profit potential of a proposed project.
D)applies only to new projects.

Question 19

Assume the following data for Project X: NPV of the project without abandonment: -$2 million; abandonment option value: $4 million.Calculate the adjusted present value (APV)of the project.

A)-$2 million
B)-$4 million
C)+$2 million
D)+$4 million

Question 20

Which of the following conditions might lead a financial manager to delay a positive-NPV project? (Assume that project NPV-if undertaken immediately-is held constant.)

A)The risk-free interest rate falls.
B)Uncertainty about future project value increases.
C)The first cash inflow generated by the project is higher than previously thought.
D)Investment required for the project increases.

Question 21

You are considering making a "Hillary" action figure to capitalize on popular political fever.Production will cost $5 million.If political fever strikes,you will sell action figures worth $20 million (in present value (PV)).If voters do not catch the political fever,you will only sell action figures worth $2 million (in PV)as only loyal Democrats will buy.Each possibility has a 50% chance.However,before production begins,you can conduct a marketing survey to determine which scenario will happen.The survey costs $1 million.Is it worth conducting the survey? Why?

A)Do not conduct the survey as the NPV without a survey = +$6 million.
B)Conduct the survey as the NPV with a survey = $6.5 million.
C)Do not conduct the survey as the NPV with a survey = $5 million.
D)Do not conduct the survey as the NPV with a survey = $4 million

Question 22

An example of a real option is:

A)the option to make follow-on investments.
B)the option to abandon a project.
C)the option to wait before investing.
D)all of the options.

Question 23

The option to wait is a type of real option.

Question 24

In terms of real options,the cash flows from the project play the same role as:

A)the stock price.
B)the exercise price.
C)dividends.
D)the variance of the underlying asset.

Question 25

Which of the following conditions might lead a financial manager to decide to expedite a positive net present value investment project?

A)The risk-free interest rate increases.
B)Uncertainty about future project value increases.
C)The cash inflows generated by the project are lower than previously thought.
D)Investment required for the project is expected to increase in the near future.

Question 26

A firm in the mining industry whose major assets are cash,equipment,and a closed facility may sell at a premium to the market value of its assets.This premium is most plausibly attributed to:

A)nearsighted investors.
B)the low exercise price held by its shareholders.
C)the option to open the facility when prices rise dramatically.
D)all of the options.

Question 27

The owner of a pro-football team expects the team to be worth either $270 million next year or $120 million,depending on whether or not she gets the city to build a new stadium.There is a 60% chance she will get a new stadium.There is a buyer willing to pay $175 million for the team right now.However,the buyer will keep his offer open-until the stadium issue is resolved-if offered some form of compensation.Given a discount rate of 7%,how much should she be willing to pay the potential buyer for a one-year option to sell the team (round to the nearest $1 million)?

A)0
B)$21 million
C)$42 million
D)$55 million

Question 28

A rational manager may be reluctant to commit to a positive net present value project when:

A)the value of the option to abandon is high.
B)the exercise price is high.
C)the opportunity cost of capital is high.
D)the value of the option to wait is high.

Question 29

Contrast the difference between the NPV of an investment and the value of the option to invest in it.
I.The value of the option to invest increases with interest rates while the NPV decreases.
II.The value of the option to invest decreases with an increase in short-term cash flows while NPV increases.
III.The value of the option to invest and the NPV of the project are unrelated.

A)I only
B)II only
C)III only
D)I and II only

Question 30

The option to expand is a type of financial option.

Question 31

Adjusted present value of project (APV)= NPV (without abandonment option)+ value of abandonment option.

Question 32

The option to make a follow-on investment is a put option.

Question 33

Consider an electric utility that may use either coal or natural gas to generate electricity.Under which of the following conditions is co-firing equipment least valuable? Let a_c be the annual standard deviation of coal prices,and let a_n be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices.

A)a_c high,a_n high,p low.
B)a_c high,a_n low,p low.
C)a_c low,a_n high,p low.
D)a_c low,a_n low,p high.

Question 34

APV = NPV (without expansion option)+ value of the expansion option.

Question 35

If an oil well allows the investor the option to drill later,what must happen for the option to be exercised?

A)Interest rates must increase.
B)The probability of oil prices increasing must be less than the probability of oil prices decreasing.
C)Oil prices must exceed the present value of future expected oil prices.
D)The present value of oil must be higher than the future value of oil.

Question 36

In real options,the required investment is considered the exercise price.

Question 37

The following are practical challenges in applying real-options analysis:
I.Real options can be complex.
II.The real options problems may not be well structured.
III.Competition may reduce or change the value of real options.

A)I only
B)I and II only
C)III only
D)I,II,and III

Question 38

Consider an electric utility that may use either coal or natural gas to generate electricity.Under which of the following conditions is co-firing equipment most valuable? Let a_c be the annual standard deviation of coal prices,and let a_n be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices.

A)a_c high,a_n high,p low.
B)a_c high,a_n low,p low.
C)a_c low,a_n high,p low.
D)a_c low,a_n low,p high.

Question 39

If projects have implied options,then:

A)the shorter the forecasted life of the project the less valuable the option is.
B)the longer the forecasted life of the project the less valuable the option is.
C)the shorter the forecasted life of the project the more valuable the option is.
D)project life does not change the value option.

Question 40

Production facilities that are flexible,in terms of the potential to use different combinations of raw material inputs,are most valuable when:

A)the product's demand is highly volatile.
B)the product's price is highly volatile.
C)raw material prices are highly volatile.
D)labor costs are highly volatile.

Question 41

Briefly explain how temporary abandonment can be thought of as a complex option.

Question 42

The first step in a real options analysis is to value the underlying asset using the discounted cash-flow (DCF)method.

Question 43

Briefly explain how abandonment value can be used to help determine project life.

Question 44

What are the four main types of real options?

Question 45

How does an abandonment option increase the value of a project?

Question 46

In an acquisition,the target firm may demand compensation from the acquiring firm if the deal falls through.The acquiring firm's compensation is for the payment of a form of a real call option.

Question 47

Briefly discuss three practical problems associated with real options analysis.

Question 48

How can managers take advantage of real options? Briefly explain.

Question 49

Explain the difference between the value of a project and the value of real options associated with a project.

Question 50

An electric utility plant that can operate on either oil or natural gas is an example of flexibility in production.

Question 51

Real options cannot be valued using the risk-neutral method since real assets do not trade in a liquid market where prices are readily observable and arbitrage opportunities are exploited immediately.

Question 52

Temporary abandonment is a very simple real option that allows the firm to stop a project temporarily until conditions improve.

Question 53

Briefly explain the implied assumption when the risk-neutral method is used for valuing real options.

Question 54

Explain the main difference between the Black-Scholes formula and the binomial method.How does this relate to real options analysis?

Question 55

How does an option to wait or postpone a project add value to the project?

Question 56

The binomial method can be used for most abandonment options.

Question 57

The risk-neutral approach is an application of the certainty equivalent method.

Question 58

Real options analysis can be used to link project life to the performance of the project.

Question 59

How does a large firm like Intel hold a natural real option on a new technology,whereas a smaller firm would not have the same option if they owned the same technology?