Answer the following five questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link in the course shell. Each question is worth five points apiece for a total of 25 points for this homework assignment.
1. Which of the following is NOT a real option?
a. The option to buy shares of stock if its price goes up.
b. The option to expand into a new geographic region.
c. The option to abandon a project.
d. The option to switch the type of fuel used in an industrial furnace.
e. The option to expand production if the product is successful.
These opportunities are options in the sense that management can, if it is in the company's best interest, undertake some action; management is not required to undertake the action. These opportunities are real (as opposed to financial) because they involve decisions regarding real assets—such as plants, equipment, and land—rather than financial assets like stocks or bonds. Four examples of real options are investment timing options, growth options, abandonment options, and flexibility options. (Bringham, 2013) Sec. 26.1
2. Which of the following will NOT increase the value of a real option?
a. An increase in the volatility of the underlying source of risk.
b. An increase in the risk-free rate.
c. An increase in the cost of obtaining the real option.
d. A decrease in the probability that a competitor will enter the market of the project in
question.
e. Lengthening the time in which a real option must be exercised.
3. Which of the following is most CORRECT?
a. Real options change the risk, but not the size, of projects' expected cash flows.
b. Real options are likely to reduce the cost of capital that should be used to discount a
project's expected cash flows.
c. Very few projects actually have real options.
d. Real options are less valuable when there is a lot of uncertainty about the true values
future sales and costs.
e. Real options change the size, but not the risk, of projects' expected cash flows.
4. 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?
a. Its estimated capital budget is probably too large due to its failure to consider
abandonment and growth options.
b. Failing to consider abandonment and flexibility options probably makes the optimal
capital budget too large, but failing to consider growth and timing options probably makes
the optimal capital budget too small, so it is unclear what impact not considering real
options has on the overall capital budget.
c. Failing to consider abandonment and flexibility options probably makes the optimal
capital budget too small, but failing to consider growth and timing options probably makes
the optimal capital budget too large, so it is unclear what impact not considering real
options has on the overall capital budget.
d. Real options should not have any effect on the size of the optimal capital budget.
e. Its estimated capital budget is probably too small, because projects' NPVs are often
larger when real options are taken into account.
5. Refer to Exhibit 26.1. 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?
a. $336.15
b. $373.50
c. $415.00
d. $461.11
e. $507.22