Question 1

A land option contract is considered what type of option?

Accepted Answer

A land option contract is an investment timing option because it gives the holder the right, but not the obligation, to purchase land at a future date, allowing them to time their investment based on market conditions.

Question 2

____ branches may emanate from a node.

Accepted Answer

There is no limit to the number of branches that may emanate from a node.

Question 3

Which of the following is not a real option?

Accepted Answer

All of the options listed are considered real options in financial analysis.

Question 4

Multidivisional firms are often unable to obtain an appropriate surrogate for determining the beta of a division. An acceptable alternative technique is to develop a beta through the division's accounting records. This is accomplished by:

Accepted Answer

The best choice is to regress the division's accounting return on equity in previous years against the return on a major stock market index. This method allows for the division's performance to be compared to the overall market, and can provide a reliable beta estimate based on past performance. Regressing projected return on equity may be less reliable since it is based on future expectations, which may not always be accurate. Regressing against a similar company may not capture the broader market risk that the division is exposed to.

Question 5

Which of the following would not be an appropriate guideline for determining the interest rate to use in discounting project cash flows in capital budgeting?

Accepted Answer

The guideline suggesting a cap on the risk premium for new ventures at five percent is not appropriate because the risk premium should reflect the actual risk of the project, which could necessitate a higher premium than five percent to accurately account for the increased risk associated with new ventures.

Question 6

Decision tree analysis shows a project to have several possible outcomes the best of which has an NPV of $10M calculated over a five year life. This best case path has an overall probability of occurring of 25%. A real option is available at an initial cost of $750,000 which will add a single $5M cash inflow to this best case path at its end. The option doesn't have a significant effect on the project's risk. The company's cost of capital is 11%. What is the option's value (to the nearest $1,000)?

Accepted Answer

The answer of Decision tree analysis shows a project to...

Question 7

The ____ method consists of regressing historical values of a division's return on equity against the return on a major stock market index.

Accepted Answer

The accounting beta model is the method that involves regressing a division's historical return on equity against the return on a major stock market index to determine its beta. This beta can then be used in the CAPM to estimate the division's required return. The overlay method involves adding a separate portfolio to an existing portfolio to achieve a desired risk/return profile. The pure play method involves using the beta of a company that is solely engaged in the same business as the division being analyzed.

Question 8

A real option's value may be more than the amount by which its inclusion in a capital budgeting project increases the project's expected NPV because the real option may:

Accepted Answer

Real options can provide benefits beyond simply increasing the expected NPV of a project. Real options can also reduce the project's risk (option to abandon or delay the project in case of unforeseen events) and reduce the loss if the project fails badly (option to switch to a different project). Hence, options A and C are correct. Option B is not always true, as the value of a real option depends on various factors such as the volatility of the underlying asset, exercise price, and time to expiration.

Question 9

An automatic bias against high-risk projects is created by:

Accepted Answer

Using a higher rate than the cost of capital when applying NPV and IRR to risky projects creates an automatic bias against high-risk projects because the higher rate reflects the additional riskiness of the project, making it harder for the project to generate a positive return. This can make high-risk projects appear less attractive than low-risk projects, even if they have the potential to generate higher returns.

Question 10

Multidivisional companies with diverse operations should use an interest rate for discounting a specific division's estimated cash flows in capital budgeting that is representative of:

Accepted Answer

Using the entire firm's cost of capital (option A) may not be appropriate as different divisions may have different risk levels and require different rates of return. Using the cost of capital obtained through the application of the pure play method (option C) may also not be appropriate as it may not adequately capture the risk of the division's cash flows. Therefore, the best choice is to use an interest rate for discounting a specific division's estimated cash flows that is representative of the riskiness of the specific division's cash flows (option B). Alternatively, if the pure play method is used to obtain the cost of capital, the interest rate obtained can also be considered as long as it adequately captures the risk of the division's cash flows. Ultimately, either option B or C can be appropriate depending on the specific circumstances of the company and the division being evaluated.

Question 11

What type of option is the right to purchase stock at a fixed price for a specified period?

Accepted Answer

The right to purchase stock at a fixed price for a specified period is a type of financial option, specifically a call option. This gives the holder the right, but not the obligation, to buy the underlying stock at the agreed-upon price (known as the strike price) for a set period of time, allowing for potential profit if the stock price goes up.

Question 12

Which of the following is likely to be true of a valuable abandonment option?

Accepted Answer

A valuable abandonment option allows for the project to be ended early if it is not performing well, reducing the project's risk. Additionally, by giving the option to abandon the project if it becomes unprofitable, the expected NPV of the project improves as it accounts for the possibility of negative outcomes being avoided. Therefore, both b. and c. are correct. Answer choices a. and d. are incorrect as the presence of a valuable abandonment option does not necessarily guarantee that all possible outcomes will have an NPV of at least zero.

Question 13

Which of the following can be a benefit of an abandonment option?

Accepted Answer

An abandonment option provides the company with the flexibility to abandon a project if it appears unprofitable, which can ultimately lower project risk. This flexibility can also lead to improved project NPV, as the company can opt to abandon the project if expected cash flows no longer meet target returns. Therefore, both options (a and c) are correct. Option B is not a benefit as it suggests that the company can delay the project, which is not the purpose of an abandonment option.

Question 14

A real option that allows a company to respond more easily to changes in business conditions is known as a(n):

Accepted Answer

A flexibility option is a real option that allows a company to respond more easily to changes in business conditions. An expansion option refers to the ability of a firm to expand its operations should the need arise, while an investment timing option refers to the ability of a firm to delay or accelerate an investment decision. Therefore, neither of these options addresses the ability to respond more easily to changes in business conditions.

Question 15

The appropriate interest rate to use in capital budgeting is:

Accepted Answer

The appropriate interest rate to use in capital budgeting is not a fixed or standard rate that can be applied to all projects. It depends on the riskiness of the project being evaluated, among other factors. Therefore, the best choice is to use the company's cost of capital, which is a weighted average of the costs of the different sources of financing used by the company, adjusted for tax implications.

However, if the project's risk is significantly different from the company's, then the interest rate used should be adjusted accordingly. If the project is riskier, the interest rate should be increased to compensate for the additional risk. This is called a risk premium. Therefore, the best choice is to use both B and C, which means the company's cost of capital should be used as a base interest rate, but adjusted with a risk premium if the project is riskier than the company's overall risk profile.

Question 16

Richmond Graphics is a small company contemplating a project with a $5M initial investment. A traditional capital budgeting analysis shows the project to have an NPV of $3.3M. However, a simple decision tree analysis reveals that the project has a 90% probability of an NPV of $4.0M and a 10 % chance of a ($3.0M) loss NPV. Management should probably:

Accepted Answer

The answer of Richmond Graphics is a small company contemplating...

Question 17

Suppose that the cost of a real option is $1 million, and that using the real option will improve the expected NPV of a project by $900,000. How should management react to the use of this real option?

Accepted Answer

Option B is correct because real options can provide flexibility and strategic advantages that are not captured in traditional NPV analysis. Therefore, if the real option provides more flexibility in how management reacts to various project outcomes, it should at least be considered for implementation.

Option C is correct because real options can also reduce the risk of a project. While the cost of the real option may be $1 million, the expected NPV improvement of $900,000 should also be weighed against the potential reduction in project risk. Management should study whether the real option reduces risk and if the potential loss of $100,000 is worth the reduced risk.

Therefore, both options B and C are correct, and the best choice is D.

Question 18

A company's cost of capital is the most appropriate discount rate to use when analyzing which type of project(s)?

Accepted Answer

The answer of A company's cost of capital is the...

Question 19

A project's possible outcomes are summarized as follows. $\begin{array}{lll}
& \text { NPV } & \text { Probability } \
\text { Worst case } & (\$ 1,000) & .2 \
\text { Most likely case } & \$ 300 & 3 \
\text { Rest case. } & \$ 600 & 5
\end{array}$ The expected NPV for the project is approximately:

Accepted Answer

The expected NPV is calculated as the sum of the products of each possible NPV and its probability. Therefore, the expected NPV is:$$(0.2) 	imes (-1,000) + (0.3) 	imes 300 + (0.5) 	imes 600 = -200 + 90 + 300 = 190$$

Question 20

When a similar company can't be found to use in estimating a divisional beta, the division's own records can sometimes be used instead. This method is called:

Accepted Answer

When a similar company cannot be found for estimating the divisional beta, the division's own records can sometimes be used instead, and this method is known as accounting beta.

Quiz 12: Risk Topics and Real Options in Capital Budgeting