Question 1

Which of the following is NOT a real option?

Accepted Answer

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

Question 2

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
-Assuming that this project will provide Rearden with perpetual annual cash flows of $80,000,Rearden should:

Accepted Answer

A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is positive. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive. 
A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is positive. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive.

Question 3

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
-Assuming that this project will provide Rearden with perpetual annual cash flows of $80,000,the NPV of investing in the project today using the hurdle rate is closest to:

Accepted Answer

A) -$281,000 
B) +$46,000 
C) +$83,000 
D) +$143,000 
E) +$238,000 
A) -$281,000 
B) +$46,000 
C) +$83,000 
D) +$143,000 
E) +$238,000

Question 4

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.

Accepted Answer

The answer of Use the information for the question(s)below.
Kinston Industries...

Question 5

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

A) $75,148 
B) $80,408 
C) $85,889 
D) $91,901 
A) $75,148 
B) $80,408 
C) $85,889 
D) $91,901

Question 6

Mutually dependent investments occur when:

Accepted Answer

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. 
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 7

The rate on a risk-free annuity that can be called at any time is known as the:

Accepted Answer

A) callable annuity rate. 
B) callable auction rate. 
C) callable hurdle rate. 
D) risk-free rate. 
A) callable annuity rate. 
B) callable auction rate. 
C) callable hurdle rate. 
D) risk-free rate.

Question 8

Which of the following statements is FALSE?

Accepted Answer

A) When the investment cannot be delayed,the optimal rule is to invest whenever the profitability index is greater than zero. 
B) It is often better to wait too long (use a profitability index criterion that is too high)than to invest too soon (use a profitability index criterion that is too low). 
C) When the source of uncertainty that creates a motive to wait is interest rate uncertainty,the hurdle rate is relatively easy to calculate. 
D) When there is an option to delay,a good rule of thumb is to invest only when the profitability index is at least 1. 
A) When the investment cannot be delayed,the optimal rule is to invest whenever the profitability index is greater than zero. 
B) It is often better to wait too long (use a profitability index criterion that is too high)than to invest too soon (use a profitability index criterion that is too low). 
C) When the source of uncertainty that creates a motive to wait is interest rate uncertainty,the hurdle rate is relatively easy to calculate. 
D) When there is an option to delay,a good rule of thumb is to invest only when the profitability index is at least 1.

Question 9

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
-Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000,and using the hurdle rate,Rearden should:

Accepted Answer

A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is positive. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive. 
A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is positive. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive.

Question 10

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.

Accepted Answer

The answer of Use the information for the question(s)below.
Kinston Industries...

Question 11

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 year's demand.Launching the new toy 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?

Accepted Answer

C = S × N(d1)- PV(K)

Question 12

Which of the following is an example of a way in which companies can create value by exploiting real options?

Accepted Answer

A) Abandoning good projects in favor of newer projects 
B) Acting quickly to take on new projects,even if there is no cost to waiting 
C) Exercising in-the-money real options immediately 
D) Optimally delaying or abandoning projects 
A) Abandoning good projects in favor of newer projects 
B) Acting quickly to take on new projects,even if there is no cost to waiting 
C) Exercising in-the-money real options immediately 
D) Optimally delaying or abandoning projects

Question 13

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
-Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,the NPV of investing in the project next year is closest to:

Accepted Answer

A) -$281,000. 
B) -$83,000. 
C) +$46,000. 
D) +$83,000. 
E) +$143,000. 
A) -$281,000. 
B) -$83,000. 
C) +$46,000. 
D) +$83,000. 
E) +$143,000.

Question 14

The two different types of node on a decision tree are:

Accepted Answer

A) information and decision nodes. 
B) information and uncertainty nodes. 
C) uncertainty and decision nodes. 
D) go to meet and stay home nodes. 
A) information and decision nodes. 
B) information and uncertainty nodes. 
C) uncertainty and decision nodes. 
D) go to meet and stay home nodes.

Question 15

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
-Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,Rearden should:

Accepted Answer

A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is negative. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive. 
A) invest today since the NPV is positive. 
B) invest today since the NPV is negative. 
C) invest today since the NPV using the hurdle rate is negative. 
D) delay investing since the NPV using the hurdle rate is negative. 
E) delay investing since the NPV using the hurdle rate is positive.

Question 16

Which of the following statements is FALSE?

Accepted Answer

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. 
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

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 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 sell the plant,draw a decision tree detailing this problem.

Accepted Answer

The answer of Use the information for the question(s)below.
You own...

Question 18

The major principles to remember when considering real options include all of the following EXCEPT:

Accepted Answer

A) out-of-the-money real options have value. 
B) in-the-money real options need to be exercised immediately. 
C) waiting is valuable. 
D) create value by exploiting real options. 
A) out-of-the-money real options have value. 
B) in-the-money real options need to be exercised immediately. 
C) waiting is valuable. 
D) create value by exploiting real options.

Question 19

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

Accepted Answer

A) $21.70. 
B) $24.00. 
C) $18.10. 
D) $16.90. 
A) $21.70. 
B) $24.00. 
C) $18.10. 
D) $16.90.

Question 20

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 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:

Accepted Answer

A) $1.0 million. 
B) $0.5 million. 
C) -$1.0 million. 
D) $3.0 million. 
A) $1.0 million. 
B) $0.5 million. 
C) -$1.0 million. 
D) $3.0 million.

Exam 22: Real Options

Which of the following is NOT a real option?

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?

Mutually dependent investments occur when:

The rate on a risk-free annuity that can be called at any time is known as the:

Which of the following statements is FALSE?

Which of the following is an example of a way in which companies can create value by exploiting real options?

The two different types of node on a decision tree are:

Which of the following statements is FALSE?

The major principles to remember when considering real options include all of the following EXCEPT:

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

The Corporation

Introduction to Financial Statement Analysis

Financial Decision Making and the Law of One Price

The Time Value of Money

Interest Rates

Valuing Bonds

Investment Decision Rules

Fundamentals of Capital Budgeting

Valuing Stocks

Capital Markets and the Pricing of Risk

Optimal Portfolio Choice and the Capital Asset Pricing Model

Estimating the Cost of Capital

Investor Behavior and Capital Market Efficiency

Capital Structure in a Perfect Market

Debt and Taxes

Financial Distress,managerial Incentives,and Information

Payout Policy

Capital Budgeting and Valuation With Leverage

Valuation and Financial Modeling: a Case Study

Financial Options

Option Valuation

Raising Equity Capital

Debt Financing

Leasing

Working Capital Management

Short-Term Financial Planning

Mergers and Acquisitions

Corporate Governance

Risk Management

International Corporate Finance

Filters