Deck 22: Real Options

Question 1

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 percent per year.

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

Answer 1

$1.21 million

Question 2

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.

Answer 2

Investment required for the project is expected to increase in the near future.

Question 3

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.

Answer 3

dividends.

Question 4

The NPV of a new video game, Dexa 1, is −1.5 million 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 10 million to start Dexa 2, which will produce 9 million of cash flow in year 2. N(d1)= 0.5785 and N(d2)= 0.1755. The annual interest rate is 11 percent and equals the risk-free rate. What is the Dexa 1 APV?

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

Question 5

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 6

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 are correct.

Question 7

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 8

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 percent per year.

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

Question 9

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 percent per year.

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

Question 10

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 11

A project is worth $12 million today without an abandonment option if the interest rate is 5 percent per year. 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 percent per year.

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

Question 12

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 13

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 14

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 15

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 16

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 alternative 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 17

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

Question 18

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

Question 19

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 20

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 21

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 22

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 be high relative to possible future prices.
D)The present value of oil must be higher than the future value of oil.

Question 23

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

Question 24

Tech Com announces a major expansion into Internet services. This announcement causes the price of Tech Com stock to increase, but also causes an increase in the volatility of the stock price. Which of the following correctly identifies the impact of these changes on the price of Tech Com call options?

A)Both changes cause the price of the call option to decrease.
B)Both changes cause the price of the call option to increase.
C)The greater uncertainty will cause the price of the call option to decrease. The higher price of the stock will cause the price of the call option to increase.
D)The greater uncertainty will cause the price of the call option to increase. The higher price of the stock will cause the price of the call option to decrease.

Question 25

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

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 are correct.

Question 27

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 28

The option to wait is a type of real option.

Question 29

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 percent 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 30

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 31

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 32

The option to expand is a type of financial 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

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 percent chance she will get a new stadium. There is a buyer willing to pay $180 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. If the interest rate is 6 percent, 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)$40 million
C)$42 million
D)$21 million

Question 35

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 36

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 37

Imagine that you are the producer of Harry Potter films. You are trying to decide whether to film the next two Harry Potter movies at the same time. If you film them both at once, you can save money on production costs, but you could lose a lot of money if the first one flops and no one goes to see the second one. Specifically, if you film them both at once, it will cost a total of $300 million, but if you film them separately, they will cost $200 million each. If the first one is successful, it will have revenues of $1 billion and the second one will have revenues of $1.5 billion. If the first one fails, it will only have revenues of $150 million and the second one will have revenues of only $50 million. If you decide to film them separately and the first one flops, you don't have to film the second one. The first film has a 50 percent chance of succeeding and a 50 percent chance of failing. Assume that all figures are given as present values (you do not need to do any additional discounting). Should you film both of them now or film them separately? Why?

A)Film them together now as NPV = $1,050 million.
B)Film them separately as NPV = $1,125 million.
C)Film them separately as NPV = $1,025 million.
D)None of the options are correct.

Question 38

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

Question 39

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

Question 40

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

Question 41

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 42

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

Question 43

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

Question 44

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

Question 45

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

Question 46

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

Question 47

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

Question 48

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

Question 49

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

Question 50

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

Question 51

What are the four main types of real options?

Question 52

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

Question 53

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?

Question 54

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 55

Briefly discuss three practical problems associated with real options analysis.

Question 56

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

Question 57

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

Question 58

The binomial method can be used for most abandonment options.