Chapter 22

Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions is co-firing equipment most valuable? Let ac be the annual standard deviation of coal prices, and let an be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices. A. ac high, an high, p low. B. ac high, an low, p low. C. ac low, an high, p low. D. ac low, an low, p high.

A. ac high, an high, p low.

If projects have implied options, then: A. the shorter the forecasted life of the project the less valuable the option is. B. the longer the forecasted life of the project the less valuable the option is. C. the shorter the forecasted life of the project the more valuable the option is. D. project life does not change the value option.

A. the shorter the forecasted life of the project the less valuable the option is.

Tech Com announces a major expansion into Internet services. This announcement causes the price of Tech Com stock to increase, but also causes an increase in the volatility of the stock price. Which of the following correctly identifies the impact of these changes on the price of Tech Com call options? A. Both changes cause the price of the call option to decrease. B. Both changes cause the price of the call option to increase. C. The greater uncertainty will cause the price of the call option to decrease. The higher price of the stock will cause the price of the call option to increase. D. The greater uncertainty will cause the price of the call option to increase. The higher price of the stock will cause the price of the call option to decrease.

B. Both changes cause the price of the call option to increase.

Which of the following conditions might lead a financial manager to delay a positive-NPV project? (Assume that project NPV—if undertaken immediately—is held constant.) A. The risk-free interest rate falls. B. Uncertainty about future project value increases. C. The first cash inflow generated by the project is higher than previously thought. D. Investment required for the project increases.

B. Uncertainty about future project value increases.

The discounted cash-flow (DCF) approach should be: A. augmented by real options analysis even if there are no imbedded options. B. augmented by added analysis if a decision has significant imbedded options. C. jettisoned if there are any embedded options. D. computed carefully to identify the options.

B. augmented by added analysis if a decision has significant imbedded options.

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.

B. limits the downside risk of an investment project.

If an oil well allows the investor the option to drill later, what must happen for the option to be exercised? A. Interest rates must increase. B. The probability of oil prices increasing must be less than the probability of oil prices decreasing. C. Oil prices must exceed the present value of future expected oil prices. D. The present value of oil must be higher than the future value of oil.

C. Oil prices must exceed the present value of future expected oil prices.

In terms of real options, the cash flows from the project play the same role as: A. the stock price. B. the exercise price. C. dividends. D. the variance of the underlying asset.

C. dividends.

Production facilities that are flexible, in terms of the potential to use different combinations of raw material inputs, are most valuable when: A. the product's demand is highly volatile. B. the product's price is highly volatile. C. raw material prices are highly volatile. D. labor costs are highly volatile.

C. raw material prices are highly volatile.

Managers who hold real options should view: A. themselves as passive onlookers with no decision making opportunities. B. real options as tools for reducing the total risk of the firm through diversification. C. real options as opportunities to alter management decisions in the future. D. themselves as agents who are looking for higher compensation.

C. real options as opportunities to alter management decisions in the future.

A firm in the mining industry whose major assets are cash, equipment, and a closed facility may sell at a premium to the market value of its assets. This premium is most plausibly attributed to: A. nearsighted investors. B. the low exercise price held by its shareholders. C. the option to open the facility when prices rise dramatically. D. all of the options.

C. the option to open the facility when prices rise dramatically.

Which of the following statements about the option to build flexibility into production facilities is true? A. Typically, production flexibility is more expensive. B. One should consider the NPV of alternate production configurations. C. Production flexibility may be valuable by enabling the firm to choose the inputs with the lowest available costs. D. All of the options are true.

D. All of the options are true.

Contrast the difference between the NPV of an investment and the value of the option to invest in it. I) The value of the option to invest increases with interest rates while the NPV decreases. II) The value of the option to invest decreases with an increase in short-term cash flows while NPV increases. III) The value of the option to invest and the NPV of the project are unrelated. A. I only B. II only C. III only D. I and II only

D. I and II only

The following are examples of expansion options: I) A mining company acquires mineral rights to land that is not worth developing today but could be profitable if ore prices increase. II) A film studio acquires the rights to produce a film based on the novel. III) A real estate developer acquires a parcel of land that could be turned into a shopping mall. IV) A pharmaceutical company purchases a patent to market a new drug. A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

D. I, II, III, and IV

Which of the following are examples of applications of real options analysis? I) a strategic investment in the computer business; II) the valuation of an aircraft purchase option; III) the option to develop commercial real estate; IV) the decision to mothball an oil tanker A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

D. I, II, III, and IV

Which of the following are examples of real options? I) the option to expand if an investment project succeeds; II) the option to wait (and learn) before investing; III) the option to shrink or abandon a project; IV) the option to vary the mix of output or the firm's production methods A. I only B. I and II only C. I, II, and III only D. I, II, III, and IV

D. I, II, III, and IV

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. A. I only B. I and II only C. III only D. I, II, and III

D. I, II, and III

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

D. IV only

The opportunity to defer investing to a later date may have value because: I) the cost of capital may increase in the near future; II) uncertainty may be increased in the future; III) the project has positive, short-term cash flows; IV) market conditions may change and increase the NPV of the project A. I only B. I and II only C. III only D. IV only

D. IV only

Which of the following conditions might lead a financial manager to decide to expedite a positive net present value investment project? A. The risk-free interest rate increases. B. Uncertainty about future project value increases. C. The cash inflows generated by the project are lower than previously thought. D. Investment required for the project is expected to increase in the near future.

D. Investment required for the project is expected to increase in the near future.

Which of the following scenarios fails to describe a possible real option embedded in a project analysis? A. A truck fleet outfitted with engines capable of running on five various types of fuel B. A patent developed on a new process of slicing bread C. A new product line started with future follow-on investments available D. The articles of incorporation amended to allow for stock splits and reverse stock splits

D. The articles of incorporation amended to allow for stock splits and reverse stock splits

Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions is co-firing equipment least valuable? Let ac be the annual standard deviation of coal prices, and let an be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices. A. ac high, an high, p low. B. ac high, an low, p low. C. ac low, an high, p low. D. ac low, an low, p high.

D. ac low, an low, p high.

An example of a real option is: A. the option to make follow-on investments. B. the option to abandon a project. C. the option to wait before investing. D. all of the options.

D. all of the options.

A rational manager may be reluctant to commit to a positive net present value project when: A. the value of the option to abandon is high. B. the exercise price is high. C. the opportunity cost of capital is high. D. the value of the option to wait is high.

D. the value of the option to wait is high.