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Exam 14: Real Options

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Question 1

Multiple Choice

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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.

F) B) and E)
G) B) and C)

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Question 2

True/False

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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.

A) True
B) False

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Question 3

True/False

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

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

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

Drilling Experts, Inc(DEI) finds and develops oil properties and then sells the successful ones to major oil refining companies DEI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars. 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. T = 1 If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned. T = 2 If the exploratory wells test positive, DEI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2 The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned. 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% cost of capital is used What is the project's expected NPV, in thousands of dollars?

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

project with an up-front cost at t=0 of $1500 is being considered by Nationwide Pharmaceutical Corporation (NPC) (All dollars in this problem are in thousands.) The project's subsequent cash flows are critically dependent on whether a competitor's product is approved by the Food and Drug Administration If the FDA rejects the competitive product, NPC's product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPCThere is a 75% chance that the competitive product will be rejected, in which case NPC's expected cash flows will be $500 at the end of each of the next seven years (t = 1 to 7) There is a 25% chance that the competitor's product will be approved, in which case the expected cash flows will be only $25 at the end of each of the next seven years (t = 1 to 7) NPC will know for sure one year from today whether the competitor's product has been approved. NPC is considering whether to make the investment today or to wait a year to find out about the FDA's decision If it waits a year, the project's up-front cost at t = 1 will remain at $1,500, the subsequent cash flows will remain at $500 per year if the competitor's product is rejected and $25 per year if the alternative product is approvedHowever, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 ..7) . 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?

Which of the following is NOT a real option?

Which of the following is most CORRECT?