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Exam 13: Real Options and Other Topics in Capital Budgeting

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Question 1

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Texas Wildcatters Inc. (TWI) t = 0. A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project. There is an 80% probability that the feasibility study would indicate that an exploratory well should be drilled. There is a 20% probability that no further work would be done. t = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill an exploratory well. The best estimate is that there is a 60% probability that the exploratory well would indicate good potential and thus that further work would be done, and a 40% probability that the outlook would look bad and the project would be abandoned. T = 2. If the exploratory well tests positive, the firm would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. T = 3. If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow. Since the project is considered to be quite risky, a 20.0% 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

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Question 2

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Real options can affect the size of a project's expected NPV but not project's risk as measured by the standard deviation or coefficient of variation of the NPV.

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Question 3

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Real options are most valuable when the underlying source of risk--such as uncertainty about unit sales, or the sales price, or input costs--is low.

An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project's sponsors and explaining why any differences occurred.

The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options.

Real options exist whenever 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.

In the previous problem you were asked to find the expected NPV of a project TWI is considering. Use the same data to calculate the project's coefficient of variation. (Hint: Use the expected NPV as found in Problem 38.)

Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no reason to consider real options separately from the NPV analysis.

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

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

Which one of the following statements best describes the most likely impact that a profitable abandonment option would have on a project's expected cash flow and risk?

In the previous problem you found the benefit from delaying an investment decision. Now use the same data to calculate the effect the delay will have on the project's risk: By how much will delaying to obtain more information reduce the project's coefficient of variation? (Hint: Use the expected NPV as found in Problem 40.)

Which one of the following statements is most CORRECT?

The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option.

Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following statements best describes the issues that the firm faces when considering this investment timing option?

Which one of the following is NOT a real option?

For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC.

Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor's larger competitors, Online Professor (OP) , is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor's program out of business, or (2) offer to buy Tutor's program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won't be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?

The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options, (3) timing options, and (4) abandonment options.

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