Deck 22: Real Options

Question 1

Which of the following statements is false?

A) If there is a lot of uncertainty, the benefit of waiting is diminished.
B) In the real option context, the dividends correspond to any value from the investment that we give up by waiting.
C) By delaying an investment, we can base our decision on additional information.
D) Given the option to wait, an investment that currently has a negative NPV can have a positive value.

Answer 1

If there is a lot of uncertainty, the benefit of waiting is diminished.

Question 2

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

A) negative NPV fallacy.
B) abandonment fallacy.
C) sunk cost fallacy.
D) dependence fallacy.

Answer 2

sunk cost fallacy.

Question 3

Describe the two factors that affect the value of an investment timing option?

Answer 3

Volatility: By delaying an investment,we can base our decision on additional information.The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.If there is little uncertainty,the benefit of waiting is diminished.
Dividends: Recall that absent dividends,it is not optimal to exercise a call option early.In the real option context,the dividends correspond to any value from the investment that we give up by waiting.It is always better to wait unless there is a cost to doing so.The greater the cost,the less attractive the option to delay becomes.

Question 4

Which of the following statements is false?

A) One way to see why you sometimes choose not to invest in a positive-NPV project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1) invest today or (2) wait.
B) You invest today only when the NPV of investing today exceeds the value of the option of waiting, which from option pricing theory we know to be always positive.
C) When you do not have the option to wait, it is optimal to invest in any positive-NPV project.
D) When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is positive but close to zero.

Question 5

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000,draw a decision tree detailing the Kinston Industries Mountain Bike Project.

Question 6

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assuming that Kinston has the ability to sell the prototype in year one for $300,000,draw a decision tree detailing the Kinston Industries Mountain Bike Project.

Question 7

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.Further assume that the probability of high or low demand is still 50%.Draw a decision tree that details Kinston Industries Mountain Bike project if Kinston goes ahead and builds the plant immediately.

Question 8

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assuming that Kinston has the ability to sell the prototype in year one for $300,000,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A) $90,000
B) $590,000
C) $455,000
D) -$45,000

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.

Question 10

Which of the following statements is false?

A) An alternative to using the Black-Scholes formula is to compute the value of growth options using risk neutral probabilities.
B) Future growth options are not only important to firm value, but can also be important in the value of an individual project.
C) While the Black-Scholes formula values American options, most growth options cannot be exercised at any time.
D) Out-of-the-money calls are riskier than in-the-money calls, and because most growth options are likely to be out-of-the-money, the growth component of firm value is likely to be riskier than the ongoing assets of the firm.

Question 11

Which of the following statements is false?

A) In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity.
B) To make an investment decision correctly, the value of embedded real options must be included in the decision-making process.
C) A key distinction between a real option and a financial option is that real options, and the underlying assets on which they are based, are often traded in competitive markets.
D) We can compute the value of the real option by comparing the expected profit without the real option to the value with the option.

Question 12

Which of the following statements is false?

A) Decision nodes are nodes in which uncertainty is involved that is out of the control of the decision maker.
B) Most investment projects allow for the possibility of reevaluating the decision to invest at a later point in time.
C) A decision tree is a graphical representation of future decisions and uncertainty resolution.
D) With binomial trees the uncertainty is not under the control of the decision maker.

Question 13

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.Assuming that the probability of high or low demand is still 50%,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A) $0
B) $90,000
C) -$45,000
D) $1,000,000

Question 14

Luther Industries is considering launching a new toy just in time for the Christmas season.They estimate that if Luther launches the new toy this year it will have an NPV of $25 million.Luther has the option to wait one year until the next Christmas season to launch the toy,however,the demand next year will depend upon what new toys Luther's competitors introduce and therefore greater uncertainty about next years demand.Launching the new today will involve a total capital expenditure of $100 million.If the risk-free rate is 5%,N(d₁)is .62 and N(d₂)is .65,then what is the value of the option to wait until next year to launch the new toy?

Question 15

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately and that the probability of high or low demand would still be 50%.What is the value of the the option to do pilot production and test marketing?

Question 16

Which of the following statements is false?

A) Aside from the current NPV of the investment, other factors affect the value of an investment and the decision to wait.
B) The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.
C) The smaller the cost of waiting, the less attractive the option to delay becomes.
D) It is always better to wait to invest unless there is a cost to doing so.

Question 17

Which of the following statements is false?

A) It is tempting to use the Black-Scholes formula to value future growth options, but often there are good reasons why this formula might not price these options correctly.
B) When a firm has a real option to invest in the future it is known as a growth option.
C) Because growth options have value, they contribute to the value of any firm that has future possible investment opportunities.
D) Future growth opportunities can be thought of as a collection of real put options on potential projects.

Question 18

Which of the following is not a real option?

A) A stock option
B) An abandonment option
C) An investment timing option
D) An expansion option

Question 19

Which of the following statements is false?

A) Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.
B) Corporate bonds often contain embedded abandonment options: The issuing firm sometimes has the option to convert the bond that is, to repay it.
C) An abandonment option is the option to walk away.
D) An important abandonment option that most people encounter at some point in their lives is the option to abandon their mortgage.

Question 20

Use the information for the question(s) below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A) -$45,000
B) $455,000
C) $590,000
D) $90,000

Question 21

Mutually dependent investments occur when

A) the value of one project depends upon the outcome of one or other projects.
B) the value of one project is independent of any other projects.
C) a firm depends on another firm to provide materials for a project.
D) consumers and producers depend on each other's investments.

Question 22

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.

Question 23

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%.
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:

A) $3.0 million
B) $6.0 million
C) $5.0 million
D) $0.5 million

Question 24

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.

Question 25

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%.
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.

Question 26

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%.
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

Question 27

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.

Question 28

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

Question 29

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%.
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

Question 30

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:

A) -$1 million
B) $5 million
C) $8 million
D) $0

Question 31

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%.
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

Question 32

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

Question 33

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:

A) $5 million
B) $8 million
C) $0
D) $4 million

Question 34

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