Question 1

Which of the following statements is FALSE?
A)Traditionally,managers have used the equivalent annual benefit method to choose between projects of different lives.
B)The equivalent annual benefit method ignores the value of any real options because it assumes that the projects will always be replaced at their original terms.
C)If the future costs (or benefits)are certain with mutually exclusive projects,then we must use a real options approach to determine the correct decision.
D)The equivalent annual benefit method accounts for the difference in project lengths by calculating the constant payment over the life of the project that is equivalent to receiving the NPV today and then selecting the project with the higher equivalent annual benefit.

Accepted Answer

This statement is false because a real options approach may still not be necessary even if future costs or benefits are certain with mutually exclusive projects. The decision between the projects can still be made using traditional methods such as net present value or equivalent annual benefit if there are no real options present. Real options would only need to be considered if there are additional uncertainties or contingencies that could affect the future cash flows of the projects.

Question 2

Use the table for the question(s)below.
Consider the following mutually exclusive projects: 
-The NPV of project A is closest to:
A)$21.70.
B)$24.00.
C)$18.10.
D)$16.90.

Accepted Answer

The answer of Use the table for the question(s)below.
Consider the...

Question 3

Use the table for the question(s)below.
Consider the following mutually exclusive projects: 
-The NPV of project B is closest to:
A)$18.10.
B)$21.70.
C)$24.00.
D)$16.90.

Accepted Answer

The answer of Use the table for the question(s)below.
Consider the...

Question 4

Use the table for the question(s)below.
Consider the following mutually exclusive projects: 
-The equivalent annual benefit of project B is closest to:
A)$5.05.
B)$5.75.
C)$3.45.
D)$3.40.

Accepted Answer

The equivalent annual benefit is calculated by dividing the total benefit of the project by the number of years over which the benefit is realized. The choice closest to the calculated value is $5.75.

Question 5

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assuming you are able to sell the plant,draw a decision tree detailing this problem.

Accepted Answer

The answer of Use the information for the question(s)below.
You own...

Question 6

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assume that it will cost $1 million to shut down the plant,but you are able to sell the plant for $5 million at any time.The value of the option to sell the plant will be closest to:
A)$3.0 million.
B)$6.0 million.
C)$5.0 million.
D)$0.5 million.

Accepted Answer

The value of the option to sell the plant is the difference between the value of the plant with the option to sell and the value of the plant without the option to sell. The value of the plant with the option to sell is the greater of the value of the plant if revenues increase by 20% and the value of the plant if revenues decrease by 25%. The value of the plant if revenues increase by 20% is $2.4 million, and the value of the plant if revenues decrease by 25% is $1.5 million. Therefore, the value of the plant with the option to sell is $2.4 million. The value of the plant without the option to sell is the present value of the future cash flows from the plant. The future cash flows from the plant are $400,000 per year (revenues of $2 million minus costs of $1.6 million). The present value of these cash flows is $4 million. Therefore, the value of the option to sell the plant is $2.4 million - $4 million = $0.4 million.

Question 7

Assume the NPV of a project is $1.5 million.The project is expected to last five years.What is the equivalent annual benefit if the discount rate is 8%?
A)$375,685
B)$300,000
C)$347,856
D)$324,000

Accepted Answer

The equivalent annual benefit (EAB) can be calculated using the formula for the annuity factor. The annuity factor for 5 years at an 8% discount rate is approximately 3.9927. Dividing the NPV of $1.5 million by this factor gives an EAB of approximately $375,685.

Question 8

The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the:
A)annualized annuity.
B)independent annual benefit.
C)equivalent annual profitability.
D)equivalent annual benefit.

Accepted Answer

The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the equivalent annual benefit (EAB). EAB is a useful tool for comparing projects with different lifetimes and making decisions based on the cash flows they generate. It represents the annual cash flow that would generate the same present value as the project's total cash flows.

Question 9

Which of the following statements is FALSE?
A)Often,the decision to abandon a project entails costs,which may be either positive or negative.
B)Mortgage interest rates are higher than Treasury rates because mortgages have an abandonment option that Treasuries do not have: You can prepay your mortgage at any time,while the U.S.government can repay its debt only according to the schedule outlined in the bond contract.
C)A popular option gives holders of the bond the option to convert the bond into equity.These kinds of bonds are termed callable bonds.
D)More often than not,there is an opportunity cost of abandoning a project: If you shut down the project and later decide to start it up again,you have to pay the costs of restarting the project.

Accepted Answer

Callable bonds give the issuer (not the holder) the option to call (or redeem) the bond before its maturity date. The statement in option C is incorrect, as convertible bonds give holders the option to convert the bond into equity.

Question 10

Rylan Inc is considering a project that has an initial cost of $2 million.It is expected to generate cash flows for the firm of $500,000 per year for 6 years.Assuming a discount rate of 7%,what is the equivalent annual benefit?
A)$75,148
B)$80,408
C)$85,889
D)$91,901

Accepted Answer

To find the equivalent annual benefit, we need to find the annual payment that would generate the same present value as the project's cost and cash flows. Using the formula for present value of an annuity, we get:

PV = C * [(1 - (1+r)^-n) / r]

Where PV is the present value, C is the annual cash flow, r is the discount rate, and n is the number of years.

Plugging in the values from the problem, we get:

PV = $2,000,000 - $500,000 * [(1 - (1+0.07)^-6) / 0.07]
PV = $1,383,097

Now we need to solve for the annual payment (C) that would give us a present value of $1,383,097. Rearranging the formula above, we get:

C = PV * r / (1 - (1+r)^-n)
C = $1,383,097 * 0.07 / (1 - (1+0.07)^-6)
C = $80,408

Therefore, the equivalent annual benefit is $80,408. Choice B is the correct answer.

Question 11

Use the table for the question(s)below.
Consider the following mutually exclusive projects: 
-Using the equivalent annual benefit method,which project would you select and why?

Accepted Answer

The answer of Use the table for the question(s)below.
Consider the...

Question 12

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assume that you are not able to sell the plant,but you are able to shut down the plant at no cost at any time.The value of the option to abandon production will be closest to:
A)$1.0 million.
B)$0.5 million.
C)-$1.0 million.
D)$3.0 million.

Accepted Answer

The answer of Use the information for the question(s)below.
You own...

Question 13

Use the table for the question(s)below.
Consider the following mutually exclusive projects: 
-The equivalent annual benefit of project A is closest to:
A)$21.70.
B)$5.05.
C)$24.00.
D)$3.40.

Accepted Answer

The answer of Use the table for the question(s)below.
Consider the...

Question 14

The idea that after making a large investment,a manager should not abandon the project is known as the:
A)negative NPV fallacy.
B)abandonment fallacy.
C)sunk cost fallacy.
D)dependence fallacy.

Accepted Answer

The idea that after making a large investment, a manager should not abandon the project is known as the sunk cost fallacy. This is because the manager is assuming that the investment made is a sunk cost and cannot be recovered, and hence, is reluctant to abandon the project. However, this decision should be based on the future potential of the project and not on the investments made in the past.

Question 15

When the value of one project depends on the outcome of one or more other projects,this is known as:
A)mutually independent investments.
B)equivalent annual investments.
C)staged dependent investments.
D)mutually dependent investments.

Accepted Answer

The value of mutually dependent investments are interrelated and depend on the outcome of one or more other projects. This means that the success or failure of one project will impact the success or failure of another project. As a result, these projects need to be evaluated and managed together, as a package.

Question 16

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-If you are not awarded the government contract and your sales decrease by 25%,then the value of your plant will be closest to:
A)-$1 million.
B)$5 million.
C)$8 million.
D)$0.

Accepted Answer

If sales decrease by 25%, revenues will be $1.5 million ($2 million - 25% of $2 million). With costs at $1.6 million, the plant will operate at a loss. Selling the plant for $5 million is the best option, as it provides a positive value compared to operating at a loss.

Question 17

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assume that you are not able to sell the plant,but you are able to shut down the plant at no cost at any time.Given the embedded option to abandon production,the value of your plant will be closest to:
A)$8.0 million.
B)$4.0 million.
C)$5.0 million.
D)$6.5 million.

Accepted Answer

The answer of Use the information for the question(s)below.
You own...

Question 18

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assume that you are not able to sell the plant,but you are able to shut down the plant,at no cost,at any time.Draw a decision tree detailing this problem.

Accepted Answer

The answer of Use the information for the question(s)below.
You own...

Question 19

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-If you are awarded the government contract and your sales increase by 20%,then the value of your plant will be closest to:
A)$5 million.
B)$8 million.
C)$0.
D)$4 million.

Accepted Answer

We can calculate the value of the plant with and without the government contract to determine the best choice.

Without government contract:
Revenues = $2 million
Costs = $1.6 million
Profit = $400,000
Plant value = $5 million (sale price)
Cost of capital = 10%

Using the formula for discounted cash flows, we can calculate the present value of the plant:
PV = CF/(1+r)^n 
PV = (400,000/(1+0.1))^1 + (400,000/(1+0.1))^2 + ... (400,000/(1+0.1)^n) + 5,000,000/(1+0.1)^n
PV = 4,000,000

With government contract:
Revenues = $2.4 million (20% increase)
Costs = $1.6 million
Profit = $800,000
Plant value = ?
Cost of capital = 10%

Using the same formula, we can calculate the present value of the plant with the increased profits:
PV = CF/(1+r)^n 
PV = (800,000/(1+0.1))^1 + (800,000/(1+0.1))^2 + ... (800,000/(1+0.1)^n) + ?/(1+0.1)^n

To determine the plant value at this new level, we can use the formula for perpetuity:
PV = CF/r
PV = 800,000/0.1
PV = $8 million

Therefore, if awarded the government contract, the value of the plant will be $8 million, which is closest to answer choice B.

Question 20

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Given the embedded option to sell the plant,the value of your plant will be closest to:
A)$5.0 million.
B)$4.0 million.
C)$6.5 million.
D)$8.0 million.

Accepted Answer

To calculate the value of the plant with the embedded option to sell, we need to use the decision tree approach.

Starting from the current year:
- Revenue: $2 million 
- Costs: $1.6 million 
- Profit: $0.4 million

Next year, there are two possible scenarios with equal probability:

- Revenue: $2.4 million ($2 million * 1.2) 
- Costs: $1.6 million 
- Profit: $0.8 million 
OR 
- Revenue: $1.5 million ($2 million * 0.75) 
- Costs: $1.6 million 
- Profit: -$0.1 million

In the first scenario, the plant generates a profit of $0.8 million, and we can choose to keep operating the plant for another year or sell it to the conglomerate for $5 million immediately. 
- If we keep operating, the value of the plant will be: 
     $0.8 million / (1 + 0.1) = $0.73 million 
- If we sell the plant, the value of the plant will be: 
     $5 million / (1 + 0.1) = $4.55 million

In the second scenario, the plant generates a loss of $0.1 million, and our only option is to sell it to the conglomerate for $5 million. 
- The value of the plant will be: 
     $5 million / (1 + 0.1) = $4.55 million

To calculate the overall value of the plant with the embedded option to sell, we need to weight the two possible scenarios by their probability:

Expected value of the plant = 0.5 * $4.55 million + 0.5 * $0.73 million 
Expected value of the plant = $2.64 million

Therefore, the closest answer choice is C) $6.5 million.

Quiz 22: Real Options

Which of the following statements is FALSE?

Use the table for the question(s) below. Consider the following mutually exclusive projects: -The NPV of project A is closest to:

Use the table for the question(s) below. Consider the following mutually exclusive projects: -The NPV of project B is closest to:

Use the table for the question(s) below. Consider the following mutually exclusive projects: -The equivalent annual benefit of project B is closest to:

Assume the NPV of a project is $1.5 million.The project is expected to last five years.What is the equivalent annual benefit if the discount rate is 8%?

The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the:

Which of the following statements is FALSE?

Rylan Inc is considering a project that has an initial cost of $2 million.It is expected to generate cash flows for the firm of $500,000 per year for 6 years.Assuming a discount rate of 7%,what is the equivalent annual benefit?

Use the table for the question(s)below. Consider the following mutually exclusive projects: -Using the equivalent annual benefit method,which project would you select and why?

Use the table for the question(s) below. Consider the following mutually exclusive projects: -The equivalent annual benefit of project A is closest to:

The idea that after making a large investment,a manager should not abandon the project is known as the:

When the value of one project depends on the outcome of one or more other projects,this is known as: