FIN Chapter 14

Relationship Between Time and Value of Option

-An option's value is higher the longer its time to expiration. -The longer the time until expiration, the greater the value of a real option.

In-The-Money

-If the strike price of a real option is less than the current value of a project's future cash flows then the option is in-the-money. -The value of a real option increases as it becomes further in-the-money.

Real Options

-Opportunities for management to change the timing, scale, or other aspects of an investment in response to changes in market conditions. -Management is not required to undertake the action -They involve decisions regarding real assets like plants, equipment and land.

Relationship Between Risk and Value of Option

-The riskier the project, the more valuable the option. -The greater the expected volatility, the greater the value of a real option.

Intrinsic Value

-The strike price of a real option determines if the option has any intrinsic value. -Intrinsic value is the difference between the strike price of the option and the current value of a project's future cash flows.

A company has an option to close down an operation if it turns out to be unprofitable.

Abandonment Option

Relationship Between Interest Rates and Value of Option

As interest rates rise, the value of a real option will increase.

Relationship Between Present Value of Future Cash Flows and Call Price

As the present value of a project's future cash flows increase, the call price increases.

Relationship Between Strike Price and Value of Option

As the strike price increases the value of a real option decreases.

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

False

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

False

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.

Flexibility Option

A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.

Growth Option

Black-Scholes Model

In the Black-Scholes Model there are six factors that influence the pricing of an option. These include the following. 1. the underlying price 2. strike price 3. time until expiration 4. volatility 5. interest rates 6. dividends

A company has an option to invest in a project today or to wait a year.

Investment Timing Option

Real Timing Option

Resembles a call option on a stock.

How to Measure Relative Variability

The coefficient of variation

Proxy for Stock Price

The proxy for stock price in the Black-Scholes Model when used for valuing a real option is the present value of the project's future cash flows.

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

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.

1. 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.

d. Waiting would probably reduce the project's risk.

1. 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.

e. Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account.