Question 1

The option to abandon a project is a real option, but a call option on a stock is not a real option.

Accepted Answer

The statement is true. An option to abandon a project is a real option because it gives the owner the right, but not the obligation, to abandon the project if certain conditions are met. On the other hand, a call option on a stock is a financial derivative that gives the owner the right to buy a specific stock at a specific price, but it is not considered a real option because it is a contractual agreement based on market conditions rather than a strategic decision-making tool.

Question 2

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

Accepted Answer

The total capital budget is an important factor in determining the weighted average cost of capital (WACC). If a company plans to raise a larger amount of capital, it may impact the WACC, which can, in turn, affect investment decisions and overall financial performance. Therefore, forecasting the total capital budget is essential for effective planning and decision-making.

Question 3

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.

Accepted Answer

Capital rationing means that a firm is limiting the amount of capital available for investment, therefore accepting fewer projects than would be theoretically optimal. As a result, the firm may not be maximizing its theoretical value.

Question 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.

Accepted Answer

The text does indeed discuss growth options, flexibility options, timing options, and abandonment options as examples of real options.

Question 5

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.

Accepted Answer

This statement is true. A firm's optimal capital budget is determined by selecting all independent projects with positive net present values (NPVs) and mutually exclusive projects that have the highest positive NPVs. This helps to optimize the firm's resources and achieve the highest possible returns on investment.

Question 6

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.

Accepted Answer

The statement accurately describes the concept of optimal capital budgeting. The optimal capital budget represents the point where the cost of funding new projects equals the return on investment from those projects. At this point, the firm is making efficient use of its financial resources and maximizing shareholder value.

Question 7

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.

Accepted Answer

The answer of The following are all examples of real...

Question 8

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

Accepted Answer

Real options refer to the ability to make decisions regarding investment in real assets, such as manufacturing plants, real estate, and other tangible assets. It is not necessarily limited to stocks and can also include bonds.

Question 9

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.

Accepted Answer

Real options refer to the ability of managers to make operating changes in response to changed conditions that affect the cash flows of a project. This is a key aspect of corporate decision-making and can have a significant impact on the success of a project. Therefore, real options are a real consideration for managers when implementing projects.

Question 10

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 low.

Accepted Answer

Real options are most valuable when the underlying source of risk is high, as they allow the company to delay or abandon a project if the future cash flows turn out to be unfavorable. Low uncertainty means that the company can make more accurate predictions about the future and may not need to exercise real options.

Question 11

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

Accepted Answer

The answer of It is not possible for abandonment options...

Question 12

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.

Accepted Answer

The answer of The following are all examples of real...

Question 13

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.

Accepted Answer

The statement is true. The true expected value of a project with a growth option takes into account the potential upside from the option, as well as the cost of obtaining it. The formula for calculating the true expected value is: Expected NPV of project with option - cost of obtaining option.

Question 14

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.

Accepted Answer

The answer of Real options can affect the size of...

Question 15

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.

Accepted Answer

The post-audit is an important part of the capital budgeting process and it involves comparing the actual results with the predicted results and explaining any differences that occurred.

Question 16

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."

Accepted Answer

The answer of Traditionally, an NPV analysis assumes that projects...

Question 17

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.

Accepted Answer

Real options allow managers to make future decisions that can significantly impact a project's value, which may not be fully captured through traditional NPV analysis. Real options analysis can provide additional insight into the value of a project by considering the flexibility available to the manager to make those future decisions. Therefore, it is important to consider real options separately from the NPV analysis.

Question 18

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.

Accepted Answer

Capital rationing occurs when a firm is limited in the amount of capital it can raise, regardless of the quality of potential projects. This can lead to the firm having to prioritize and choose only the best projects to pursue with the limited funds available.

Question 19

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.

Accepted Answer

This statement is true. Companies do have the option to delay decisions until later when more information is available, which can impact the NPV analysis.

Question 20

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.

Accepted Answer

Real options are the additional investment opportunities that a project may generate, and traditional DCF analysis does not account for these options. This can result in incorrect capital budgeting decisions. Therefore, it is true that DCF techniques do not always lead to proper capital budgeting decisions due to real options.

Quiz 13: Real Options and Other Topics in Capital Budgeting