Deck 22: Real Options

Question 1

A project is worth $12 million today without an abandonment option. Suppose the value of the project is $18 million one year from today with high demand and $8 million with low demand. It is possible to sell off the project for $10 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the risk-neutral valuation]
A. $1.03 million.
B. $2 million.
C. $1.9 million.
D. None of the above.

Answer 1

[Use the risk-neutral valuation]A.

Question 2

Rejecting an investment today forever might not be a good choice because:
I. The size of the firm will decline.
II. There are always errors in the estimation of the NPVs.
III. The option value is negative.
IV. The company is foregoing future rights or the option to make the investment 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 2

IV only

Question 3

The discounted cash flow (DCF) approach must be:

A) Augmented by added analysis 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.

Answer 3

Augmented by added analysis if a decision has significant imbedded options.

Question 4

Given 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) none of the above

Question 5

The following are examples of expansion options:
I. A mining company may acquire rights to an ore body that is not worth developing today but could be profitable if product prices increase
II. A film producing company acquiring the rights to a novel to produce a film based on the novel in the future
III. A real estate developer may acquire a parcel of land that could be turned into a shopping mall
IV. A pharmaceutical company may acquire 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 6

Suppose the oil price is uncertain and can be $60/bbl or $30/bbl next year with equal probability, then expected NPV of the project if postponed by one year is: (approximately)

A) +50 million
B) -25 million
C) +59 million
D) None of the above

Question 7

Which of the following conditions might lead a financial manager to delay a positive NPV
Project? Assume 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 lower than previously thought.
D) Investment required for the project increases.

Question 8

Calculate the NPV to invest today.

A) +40 million
B) +75 million
C) +25 million
D) None of the above

Question 9

Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $50 million (C0) and is expected to remain constant. The
Price of oil P is $60/bbl and the extraction costs are $35/bbl. The quantity of oil Q = 300,000 bbl per year forever. The risk-free rate is 6% per year and that is also the cost of capital (Ignore taxes). The firm has constructed the oil rig and a year later the oil price has plummeted to $30/bbl. The firm can cap the rig at a cost of $10 million. The firm can restart pumping when oil is price more favorable. Calculate the NPV of capping the rig: (abandonment option).

A) +$25 million
B) +$10 million
C) +$15 million
D) None of the above

Question 10

Suppose 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 is:

A) +34 million
B) +25 million
C) +59 million
D) None of the above

Question 11

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

A) Typically is more expensive.
B) Must consider the NPV of alternative uses.
C) May be valuable by allowing reconfiguration to produce of goods or service with higher profit.
D) All of the above are true.

Question 12

The opportunity to invest in a project can be thought of as a three-year real option that is worth $500 million with an exercise price of $800 million. Calculate the value of the option given that, N(d1) = 0. 3 and N(d2) = 0.15. Assume that the interest is 6% per year.

A) $150 million
B) $49.25 million
C) Zero
D) None of the above.

Question 13

The opportunity to invest in a project can be thought of as a two year option on an asset which is worth $400 million (PV of the cash flows from the project) with an exercise price of
$600 million (investment needed). Calculate the value of the option given that N(d1) = 0.6 and
N(d2) = 0.4 and interest rate is 6%.

A) $26.4 million
B) Zero
C) $200 million.
D) None of the above.

Question 14

A project is worth $15 million today without an abandonment option. Suppose the value of the project is $20 million one year from today with high demand and $10 million with low demand. It is possible to sell off the project for $13 million if the demand is low. Calculate the value of the abandonment option if the discount rate is 5% per year. [Use the replicating portfolio method]
A. $1.21 million.
B. $2.86 million.
C. $1.9 million.
D. None of the above.

Question 15

Managers who hold real options can view:

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

Question 16

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 or 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 17

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. Investment costs fluctuate over time.
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 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

The following are the main types of real options:
I. The option to expand if the immediate 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 only

Question 20

Which of the following statements about a project's economic life is (are) true?

A) most project's economic lives are not known with certainty at the start.
B) a new product may last only for a year or less if the product fails in the marketplace.
C) a new product if successful, could last for several years (with improvements or variations).
D) all of the above are true.

Question 21

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 22

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

Question 23

Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be most valuable to have co-firing equipment? 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 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 price volatility of the stock. Which of the following correctly identifies the impact of these changes on the call option of Tech Com?

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

Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions would it be the least valuable to have co-firing equipment? 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 26

Production facilities that are flexible in terms of possible raw materials used are most valuable when:

A) Product demand is highly volatile.
B) Product price is highly volatile.
C) Raw material prices are highly volatile.
D) Labor costs are highly volatile.

Question 27

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

Question 28

Which of the following conditions might lead a financial manager to decide to expedite a positive Net Present Value investment project that previously he/she had decided to delay?

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

Question 29

A firm in the extraction industry whose major assets are cash, equipment and a closed facility may appear to have extraordinary value. This value can be primarily attributed to:

A) The potential sale of the company.
B) The low exercise price held by the shareholders.
C) The option to open the facility when prices rise dramatically.
D) All of the above.

Question 30

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, but will not keep the offer open without some form of compensation. Given a discount rate of 7%, how much should she be willing to pay for the option to sell the team?

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

Question 31

You are considering making a "Hillary" action figure to capitalize on what you are sure will be a massive resurgence political fever. Production will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present value (PV)). If the voters do not catch the political fever, you will only sell action figures worth $2 (in PV) million as only loyal democrats will buy. Each has a 50% chance of happening. Before beginning production, 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 E(NPV without survey) = +$6 million
B) Conduct the survey as the E(NPV with survey) = $6.5 million
C) Do not conduct the survey as the E(NPV with survey) = $5 million
D) None of the above

Question 32

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

A) The stock price.
B) The exercise price.
C) The dividends.
D) The variance.

Question 33

If projects have implied options.

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

Question 34

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 35

The option to expand is a type of financial option.

Question 36

The option to wait is a type of real option.

Question 37

The difference between the NPV of the investment and the value of the option to invest is:
I. The value for the option to invest still have a positive value at high interest rates while the NPV could be negative.
II. The value of the option to invest has a negative value at low interest rates while NPV
Could have high positive value.
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) II and III only

Question 38

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

A) Increase in interest rates
B) The probability of oil prices increasing must be less than the probability price decreases
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 39

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 above.

Question 40

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% chance of succeeding and a 50% 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 E(NPV) = $1,050 million
B) Film them separately as E(NPV) = $1,125 million
C) Film them separately as E(NPV) = $1,025 million
D) None of the above

Question 41

What are the four main types of real options?

Question 42

The binomial method can be used for most abandonment options.

Question 43

Briefly explain the implied assumption when 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

Explain the main difference between the Black-Scholes formula and the binomial method.

Question 46

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

Question 47

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

Question 48

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

Question 49

How can managers create real options? Briefly explain.

Question 50

Briefly discuss three practical problems associated with real options analysis.

Question 51

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

Question 52

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

Question 53

Real estate developers who buy options on farm land around a big city expect to exercise most of their options.

Question 54

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

Question 55

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

Question 56

The owner of a professional sports franchise, looking to get a new stadium, would benefit from a put option if the deal falls through.

Question 57

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

Question 58

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

Question 59

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

Question 60

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

Question 61

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