Question 1

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 dollars 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:

Accepted Answer

If the government contract is awarded and the sales increase by 20%, the new revenue will be $2.4 million per year ($2 million * 1.2). Subtracting the cost of $1.6 million per year, the profit will be $0.8 million per year ($2.4 million - $1.6 million). To calculate the value of the plant, we can use the perpetuity formula: 
Value of plant = ($0.8 million / 0.1)
Value of plant = $8 million

Since the value of the plant is higher than the selling price of $5 million, it would be best to continue operating the plant and not sell it.

Question 2

Which of the following statements is FALSE?

Accepted Answer

This statement is false because a real options approach is typically used when there is uncertainty or flexibility in future costs or benefits, not when they are certain. The equivalent annual benefit method is used when comparing projects of different lives and calculates the constant payment over the life of the project that is equivalent to receiving the NPV today, taking into account the difference in project lengths. It does not account for any real options as it assumes the projects will be replaced at their original terms.

Question 3

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 dollars 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:

Accepted Answer

If sales decrease by 25%, the new annual revenue will be $1.5 million. Subtracting the cost of other costs, the annual profit will be $-0.1 million ($1.5 million - $1.6 million). Using a perpetuity formula with a yearly cash flow of -$0.1 million and a cost of capital of 10%, the value of the plant is approximately $5 million. Therefore, the best choice is to sell the plant immediately for $5 million.

Question 4

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

Accepted Answer

The equivalent annual benefit (EAB) is the constant annuity payment over the life of a project that is equivalent to receiving the net present value (NPV) today. It provides a way to compare projects with different lifetimes and cash flows, and helps to determine which project is the more profitable one on an annual basis. Option A is incorrect because there is no such term as "annualized annuity." Option B is incorrect because "independent annual benefit" does not exist as a term. Option C is incorrect as "equivalent annual profitability" is not the correct term for this concept.

Question 5

Mutually dependent investments occur when:

Accepted Answer

Mutually dependent investments occur when the value of one project depends upon the outcome of one or other projects. This means that the success of one project is closely tied to the success of another project, and they cannot be evaluated independently.

Question 6

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:

Accepted Answer

The answer of Assume that you are not able to...

Question 7

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?

Accepted Answer

To calculate the equivalent annual benefit, we need to determine the annuity payment that would have the same present value as the project.

Using the formula for present value of an annuity:

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

where PV is present value, C is the cash flow, r is the discount rate, and n is the number of periods.

Calculating the present value of the project:

PV = 500,000 x [1 - (1+0.07)^(-6)]/0.07
PV = $2,660,233.92

So the equivalent annual benefit is:

EAB = $2,660,233.92 / 6
EAB = $443,372.32

Therefore, the closest option is B) $80,408 as it is the closest to the calculated EAB value.

Question 8

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:

Accepted Answer

The option to abandon production has value because it provides flexibility and reduces downside risk. Since shutting down the plant has no cost, the option value is equal to the cost savings from avoiding losses in a bad market. Therefore, the option value should be negative and closest to the amount of expected losses in a bad market. We can assume that the expected losses in a bad market are $0.5 million, which is closest to option value B of $0.5 million. The other options are too high or too low.

Question 9

Assume that it will cost you $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:

Accepted Answer

The value of the option to sell the plant can be calculated using the Black-Scholes option pricing model. However, since this is a simple example with no other variables involved, we can use a simpler approach.

The value of the option is the difference between the value of the asset if you sell it and the cost of shutting it down. In this case, the value of the asset is $5 million and the cost of shutting it down is $1 million. Therefore, the value of the option is $5 million - $1 million = $4 million.

However, it is important to remember that the option to sell the plant is only valuable if the market price of the plant is greater than the option value. If the market price is below $4 million, it would be more economical to shut down the plant. Therefore, the value of the option is the maximum of $4 million or the difference between the market price and the shut down cost.

Given that we know the market price is $5 million, the value of the option would be the maximum of $4 million or $5 million - $1 million = $4 million. Therefore, the closest answer choice is A) $3.0 million.

Question 10

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

Accepted Answer

When the value of one project depends on the outcome of one or more other projects, it is known as mutually dependent investments. This means that the success of one project is interconnected with the success of another project. It is important to consider the interdependence of projects when making investment decisions in order to accurately assess the potential risks and rewards.

Question 11

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%?

Accepted Answer

The answer of Assume the NPV of a project is...

Question 12

Assuming you are able to see the plant, draw a decision tree detailing this problem.

Accepted Answer

The answer of Assuming you are able to see the...

Question 13

Using the equivalent annual benefit method, which project would you select and why?

Accepted Answer

The answer of Using the equivalent annual benefit method, which...

Question 14

The equivalent annual benefit of project B is closest to:

Accepted Answer

To calculate the equivalent annual benefit, we first need to calculate the present value of all cash inflows and outflows for each year of the project. For project B, we have the following:

Year 0: -10
Year 1: 5
Year 2: 12

Using a discount rate of 10%, we can calculate the present value of each year's cash flow using the formula PV = CF / (1 + r)^n, where CF is the cash flow, r is the discount rate, and n is the number of years in the future the cash flow occurs.

PV of Year 0: -10 / (1 + 0.10)^0 = -10
PV of Year 1: 5 / (1 + 0.10)^1 = 4.55
PV of Year 2: 12 / (1 + 0.10)^2 = 9.92

The sum of these present values is 4.47. To calculate the equivalent annual benefit, we divide the sum of the present values by the annuity factor, which can be looked up in a present value of an annuity table. For a 2-year annuity at 10%, the annuity factor is 1.73554.

Equivalent Annual Benefit = 4.47 / 1.73554 = 2.58

To convert this to the closest option, we need to multiply by 2 because the answer is asking for the equivalent annual benefit for two identical projects.

2 x 2.58 = 5.16

The closest option is B, $5.75.

Question 15

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

Accepted Answer

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

Question 16

Given the embedded option to sell the plant, the value of your plant will be closest to:

Accepted Answer

The embedded option to sell the plant gives the owner the right to sell the plant at a predetermined price of $6.5 million. This means that even if the value of the plant decreases, the owner can still sell it at the higher price. Therefore, the value of the plant with the embedded option will be closest to $6.5 million.

Question 17

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 Assume that you are not able to...

Question 18

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

Accepted Answer

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

Question 19

The idea that once a manager makes a large investment, he should not abandon the project is known as the:

Accepted Answer

The sunk cost fallacy refers to the idea that once a manager has invested resources (money, time, or effort) into a project, these costs are irretrievable and should not be taken into account when deciding whether to continue with the project or not. In other words, sunk costs should not influence future decisions because they are already spent and cannot be recovered. Therefore, if a manager decides to continue investing in a project simply because they have already poured a lot of money into it, they are committing the sunk cost fallacy.

Question 20

The equivalent annual benefit of project A is closest to:

Accepted Answer

The answer of The equivalent annual benefit of project A...

Quiz 22: Real Options

Which of the following statements is FALSE?

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

Mutually dependent investments occur when:

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:

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?

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:

Assume that it will cost you $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:

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

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%?

Assuming you are able to see the plant, draw a decision tree detailing this problem.

Using the equivalent annual benefit method, which project would you select and why?

The equivalent annual benefit of project B 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:

Given the embedded option to sell the plant, the value of your plant will be closest to:

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.

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

The idea that once a manager makes a large investment, he should not abandon the project is known as the:

The equivalent annual benefit of project A is closest to: