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Homework answers / question archive / Corporate Finance, 3e (Berk/DeMarzo) Chapter 22   Real Options 22

Corporate Finance, 3e (Berk/DeMarzo) Chapter 22   Real Options 22

Finance

Corporate Finance, 3e (Berk/DeMarzo)

Chapter 22   Real Options

22.1)   Real Versus Financial Options

1) Which of the following statements is FALSE?

A) In particular, because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity.

B) To make an investment decision correctly, the value of embedded real options must be included in the decision-making process.

C) A key distinction between a real option and a financial option is that real options, and the underlying assets on which they are based, are often traded in competitive markets.

D) We can compute the value of the real option by comparing the expected profit without the real option to the value with the option.

 

2) Which of the following is NOT a real option?

A) A stock option

B) An abandonment option

C) An investment timing option

D) An expansion option

 

22.2   Decision Tree Analysis

 

1) Which of the following statements is FALSE?

A) Decision nodes are nodes in which uncertainty is involved that is out of the control of the decision maker.

B) Most investment projects allow for the possibility of reevaluating the decision to invest at a later point in time.

C) A decision tree is a graphical representation of future decisions and uncertainty resolution.

D) With binomial trees the uncertainty is not under the control of the decision maker.

 

2) The two different types of node on a decision tree are:

A) information and decision nodes.

B) information and uncertainty nodes.

C) uncertainty and decision nodes.

D) go to meet and stay home nodes.

 

22.3   The Option to Delay an Investment Opportunity

 

1) Which of the following statements is FALSE?

A) One way to see why you sometimes choose not to invest in a positive-NPV project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1) invest today or (2) wait.

B) You invest today only when the NPV of investing today exceeds the value of the option of waiting, which from option pricing theory we know to be always positive.

C) When you do not have the option to wait, it is optimal to invest in any positive-NPV project.

D) When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is positive but close to zero.

 

2) Which of the following statements is FALSE?

A) If there is a lot of uncertainty, the benefit of waiting is diminished.

B) In the real option context, the dividends correspond to any value from the investment that we give up by waiting.

C) By delaying an investment, we can base our decision on additional information.

D) Given the option to wait, an investment that currently has a negative NPV can have a positive value.

3) Which of the following statements is FALSE?

A) Aside from the current NPV of the investment, other factors affect the value of an investment and the decision to wait.

B) The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.

C) The smaller the cost of waiting, the less attractive the option to delay becomes.

D) It is always better to wait to invest unless there is a cost to doing so.

 

 

Use the information for the question(s) below.

 

 

4) Describe the two factors that affect the value of an investment timing option?

5) Luther Industries is considering launching a new toy just in time for the Christmas season.  They estimate that if Luther launches the new toy this year it will have an NPV of $25 million.  Luther has the option to wait one year until the next Christmas season to launch the toy, however, the demand next year will depend upon what new toys Luther's competitors introduce and therefore greater uncertainty about next years demand.  Launching the new today will involve a total capital expenditure of $100 million.  If the risk-free rate is 5%, N(d1) is .62 and N(d2) is .65, then what is the value of the option to wait until next year to launch the new toy?

22.4   Growth and Abandonment Options

 

1) Which of the following statements is FALSE?

A) It is tempting to use the Black-Scholes formula to value future growth options, but often there are good reasons why this formula might not price these options correctly.

B) When a firm has a real option to invest in the future it is known as a growth option.

C) Because growth options have value, they contribute to the value of any firm that has future possible investment opportunities.

D) Future growth opportunities can be thought of as a collection of real put options on potential projects.

2) Which of the following statements is FALSE?

A) An alternative to using the Black-Scholes formula is to compute the value of growth options using risk neutral probabilities.

B) Future growth options are not only important to firm value, but can also be important in the value of an individual project.

C) While the Black-Scholes formula values American options, most growth options cannot be exercised at any time.

D) Out-of-the-money calls are riskier than in-the-money calls, and because most growth options are likely to be out-of-the-money, the growth component of firm value is likely to be riskier than the ongoing assets of the firm.

 

3) Which of the following statements is FALSE?

A) Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.

B) Corporate bonds often contain embedded abandonment options: The issuing firm sometimes has the option to convert the bond—that is, to repay it.

C) An abandonment option is the option to walk away.

D) An important abandonment option that most people encounter at some point in their lives is the option to abandon their mortgage.

4) Which of the following statements is FALSE?

A) Often, the decision to abandon a project entails costs, which may be either positive or negative.

B) Mortgage interest rates are higher than Treasury rates because mortgages have an abandonment option that Treasuries do not have: You can prepay your mortgage at any time, while the U.S. government can repay its debt only according to the schedule outlined in the bond contract.

C) A popular option gives holders of the bond the option to convert the bond into equity. These kinds of bonds are termed callable bonds.

D) More often than not, there is an opportunity cost of abandoning a project: If you shut down the project and later decide to start it up again, you have to pay the costs of restarting the project.

5) The idea that once a manager makes a large investment, he should not abandon the project is known as the:

A) negative NPV fallacy.

B) abandonment fallacy.

C) sunk cost fallacy.

D) dependence fallacy.

 

 

22.5   Applications to Multiple Projects

 

1) Which of the following statements is FALSE?

A) Traditionally, managers have used the equivalent annual benefit method to choose between projects of different lives.

B) The equivalent annual benefit method ignores the value of any real options because it assumes that the projects will always be replaced at their original terms.

C) If the future costs (or benefits) are certain with mutually exclusive projects, then we must use a real options approach to determine the correct decision.

D) The equivalent annual benefit method accounts for the difference in project lengths by calculating the constant payment over the life of the project that is equivalent to receiving the NPV today and then selecting the project with the higher equivalent annual benefit.

2) The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the:

A) annualized annuity.

B) independent annual benefit.

C) equivalent annual profitability.

D) equivalent annual benefit.

3) Assume the NPV of a project is $1.5 million.  The project is expected to last five years.  What is the equivalent annual benefit if the discount rate is 8%?

A) $375,685

B) $300,000

C) $347,856

D) $324,000

 

4) Rylan Inc is considering a project that has an initial cost of $2 million.  It is expected to generate cash flows for the firm of $500,000 per year for 6 years.  Assuming a discount rate of 7%, what is the equivalent annual benefit?

A) $75,148

B) $80,408

C) $85,889

D) $91,901

 

5) When the value of one project depends on the outcome of one or more other projects, this is known as:

A) mutually independent investments.

B) equivalent annual investments.

C) staged dependent investments.

D) mutually dependent investments.

6) Mutually dependent investments occur when:

A) the value of one project depends upon the outcome of one or other projects.

B) the value of one project is independent of any other projects.

C) a firm depends on another firm to provide materials for a project.

D) consumers and producers depend on each other's investments.

 

7) Which of the following statements is FALSE?

A) The profitability index rule of thumb raises the bar on the NPV to take into account the option to wait.

B) In practice, correctly modeling the sources of uncertainty and the appropriate dynamic decisions usually requires an extensive amount of time and financial expertise.

C) Some firms use the following rule of thumb: Invest whenever the profitability index is below a specified level.

D) Instead of raising the bar on the NPV, the hurdle rate rule raises the discount rate.

 

8) Which of the following statements is FALSE?

A) When the investment cannot be delayed, the optimal rule is to invest whenever the profitability index is greater than zero.

B) It is often better to wait too long (use a profitability index criterion that is too high) than to invest too soon (use a profitability index criterion that is too low).

C) When the source of uncertainty that creates a motive to wait is interest rate uncertainty, the hurdle rate is relatively easy to calculate.

D) When there is an option to delay, a good rule of thumb is to invest only when the profitability index is at least 1.

 

9) Which of the following statements is FALSE?

A) The hurdle rate rule for projects with the option to delay uses a lower discount rate than the cost of capital to compute the NPV, but then applies the regular NPV rule: Invest whenever the NPV calculated using this lower discount rate is positive.

B) While using a hurdle rate rule for deciding when to invest might be a cost-effective way to make investment decisions, it is important to remember that this rule does not provide an accurate measure of value.

C) When the cash flows are constant and perpetual, and the reason to wait derives solely from interest rate uncertainty, the hurdle rate rule of thumb is always exact.  However, when these conditions are not satisfied, the rule of thumb merely approximates the correct decision.

D) When a firm faces the same uncertainty for most of its investment decisions, using a single profitability index criterion for all projects can provide a useful rule of thumb to account for cash flow uncertainty.

 

10) The rate on a risk-free annuity that can be called at any time is known as the:

A) callable annuity rate.

B) callable auction rate.

C) callable hurdle rate.           

D) risk-free rate.

 

11) The callable annuity rate can be calculated as:

A)

 × Hurdle Rate

 

B)

 × Hurdle Rate

 

C)

 × Cost of Capital

 

D)

 

22.6  Key Insights from Real Options

 

1) The major principles to remember when considering real options include all of the following EXCEPT:

A) out-of-the-money real options have value.

B) in-the-money real options need to be exercised immediately.

C) waiting is valuable.

D) create value by exploiting real options.

 

2) Which of the following is an example of a way in which companies can create value by exploiting real options?

A) Abandoning good projects in favor of newer projects

B) Acting quickly to take on new projects, even if there is no cost to waiting

C) Exercising in-the-money real options immediately

D) Optimally delaying or abandoning projects

3) Do out-of-the-money real options have value?

4) Can value be created by waiting for uncertainty to resolve?

Option 1

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