Exam 26: Real Options

Refer to the data for Garner-Wagner Incorporated.If Garner-Wagner goes ahead with this project today,it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5).The company can decide at t = 5 whether or not it wants to pursue these additional opportunities.Based on the best information available today,there is a 35% probability that the outlook will be favorable,in which case the future investment opportunity will have a net present value of $6 million at t = 5.There is a 65% probability that the outlook will be unfavorable,in which case the future investment opportunity will have a net present value of −$6 million at t = 5.Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity.Instead,it can wait to see what the outlook is.However,the company cannot pursue the future opportunity unless it makes the $3 million investment today.What is the estimated net present value of the project,after consideration of the potential future opportunity?

Which of the following is NOT a real option?

Refer to data for Steppingstone Incorporated (SI).Now assume that one year from now SI will know if the Z−45 has become the industry standard.Also assume that after receiving the cash flows at t = 1,SI has the option to abandon the project,in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1.Assuming that the cost of capital remains at 12%,what is the estimated value of the abandonment option?

The option to abandon a project is a real option,but a call option on a stock is not a real option.

Refer to the data for Garner-Wagner Incorporated.Based on the above data,what is the project's net present value?

Refer to the data for Drilling Experts.Calculate the project's coefficient of variation.(Hint: Use the expected NPV. )

Which of the following is most CORRECT?

Refer to the data for Nationwide Pharmaceutical Corporation (NPC).Assuming that all cash flows are discounted at 10%,if NPC chooses to wait a year before proceeding,how much will this increase or decrease the project's expected NPV in today's dollars ,relative to the NPV if it proceeds today?

Refer to data for Steppingstone Incorporated.Based on the above information,what is the Z−90's expected net present value?

Real options exist when managers have the opportunity,after a project has been implemented,to make operating changes in response to changed conditions that modify the project's cash flows.

Refer to the data for Nationwide Pharmaceutical Corporation (NPC).Calculate the effect of waiting on the project's risk,using the same data.By how much will delaying reduce the project's coefficient of variation? (Hint: Use the expected NPV. )

Which one of the following is an example of a "flexibility" option?

Real options affect the size,but not the risk,of a project's expected cash flows.

Real options are most valuable when the underlying source of risk is very low.

Which of the following will NOT increase the value of a real option?

Ashgate Enterprises uses the NPV method for selecting projects,and it does a reasonably good job of estimating projects' sales and costs.However,it never considers real options that might be associated with projects.Which of the following statements is most likely to describe its situation?

Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co.The project has a positive expected NPV,but its cash flows could be less than expected,in which case the NPV could be negative.No competitors are likely to invest in a similar project if Aaron decides to wait.Which of the following statements best describes the issues that Aaron faces when considering this investment timing option?

Real options are options to buy real assets,like stocks,rather than interest-bearing assets,like bonds.

Refer to the data for Drilling Experts,Incorporated.Since the project is considered to be quite risky,a 20% cost of capital is used.What is the project's expected NPV,in thousands of dollars?