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Exam 22: Real Options

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Question 21

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Permanently rejecting an investment today might not be a good choice because: I.the size of the firm will decline; II.there are always errors in the estimation of NPVs; III.the project's real option value is negative; IV.the company is forgoing the option to make the investment in the future if economic and industry conditions change for the better

A) I only
B) II only
C) I,II,and III only
D) IV only

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Question 22

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An abandonment option,in effect,

A) limits the flexibility of management's decision-making.
B) limits the downside risk of an investment project.
C) limits the profit potential of a proposed project.
D) applies only to new projects.

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Question 23

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What are the four main types of real options?

The discounted cash-flow (DCF) approach should be:

The following are practical challenges in applying real-options analysis: I.Real options can be complex. II.The real options problems may not be well structured. III.Competition may reduce or change the value of real options.

Explain the main difference between the Black-Scholes formula and the binomial method.How does this relate to real options analysis?

If an oil well allows the investor the option to drill later,what must happen for the option to be exercised?

Adjusted present value of project (APV)= NPV (without abandonment option)+ value of abandonment option.

How can managers take advantage of real options? Briefly explain.

Real options cannot be valued using the risk-neutral method since real assets do not trade in a liquid market where prices are readily observable and arbitrage opportunities are exploited immediately.

A project is worth $15 million today without an abandonment option.Suppose the value of the project is either $20 million one year from today (if product demand is high) or $10 million (if product demand is low) .It is possible to sell off the project for $13 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.

Which of the following statements about the option to build flexibility into production facilities is true?

In real options,the required investment is considered the exercise price.

A project is worth $12 million today without an abandonment option.Suppose the value of the project is either $18 million one year from today (if product demand is high) or $8 million (if product demand is low) .It is possible to sell off the project for $10 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.

The risk-neutral approach is an application of the certainty equivalent method.

How does a large firm like Intel hold a natural real option on a new technology,whereas a smaller firm would not have the same option if they owned the same technology?

A rational manager may be reluctant to commit to a positive net present value project when:

A firm has a two-year real option to invest in a project that has a present value of $400 million with an exercise price (in year 2) of $600 million.Calculate the value of the option given that N(d₁) = 0.6 and N(d₂) = 0.4.Assume that the risk-free interest rate is 6% per year.

Briefly explain how temporary abandonment can be thought of as a complex option.

Suppose that the oil price is uncertain and can be $60/bbl.or $30/bbl.next year with equal probability.Then the value of the option to postpone the project by one year equals: