Chapter 26

What are the four examples of real options

1- Timing options 2- Growth options 3- Abandonment options 4- Flexibility options

List the five possible procedures for dealing with real options.

1. Use discounted cash flow (DCF) valuation and ignore any real options by assuming their values are zero. 2. Use DCF valuation and include a qualitative recognition of any real option's value. 3. Use decision-tree analysis. 4. Use a standard model for a financial option. 5. Develop a unique, project-specific model using financial engineering techniques.

Which one of the following is an example of a "flexibility" option? a. A company has an option to close down an operation if it turns out to be unprofitable. b. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or outputs at a later date if conditions change. c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date. d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial. e. A company has an option to invest in a project today or to wait a year.

ANSWER: b RATIONALE: Statements a, b, c, and e are all examples of different types of real options. A flexibility option permits the firm to alter operations depending on how conditions change during the life of the project. Typically, either inputs or outputs, or both, can be changed.. Statement a is an example of an abandonment option. Statement b is an example of a flexibility option and statement c is an example of a growth option. Statement d is not really a real option at all. Statement e is an example of an investment timing option. Therefore, statement b is the correct choice.

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? a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today. b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year. c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV. d. Waiting would probably reduce the project's risk. e. The investment timing option does not affect the cash flows and will therefore have no impact on the project's risk.

ANSWER: d RATIONALE: By having the ability to wait and see you reduce the risk of the project. Therefore, statement e is false. The greater the uncertainty, the more value there is in waiting for additional information before going on with a project. Therefore, statement a is false. Statements b and c are not necessarily true. By waiting to do a project you may lose strategic advantages associated with being the first competitor to enter a new line of business, which may alter the cash flows. Since statements a, b, c, and e are false, the correct choice is statement d.

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.

ANSWER: e RATIONALE: By failing to consider real options, the firm's capital budget would probably be too small. The firm might well reject projects that would be seen to have positive expected NPVs if real options had been considered. Therefore, the correct choice is statement e.

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

False

Real options are most valuable when the underlying source of risk is very low. a. True b. False

False

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

False

Define Options

The right (but not the obligation) to take some action in the future

Projects that expand the firm's set of opportunities have positive option values and project that reduces the set of future opportunities destroys option value. True False

True

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. a. True b. False

True

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

True

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.

a. The option to buy shares of stock if its price goes up.

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.

b. Real options are likely to reduce the cost of capital that should be used to discount a project's expected cash flows.

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.

c. An increase in the cost of obtaining the real option.