Chapter 22

Real Options

Multiple Choice Questions

1. 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

2. 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

22-1
3. 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.

4. A firm has a three-year real option to invest in a project that has a present value of $500 million with an
exercise price (in year 3) of $800 million. Calculate the value of the option given that N(d1) = 0.3 and N(d2)
= 0.15. Assume that the risk-free interest rate is 6% per year.

A. $30.00 million
B. $49.25 million
C. zero
D. $7.08 million

5. A firm has a two-year real option to invest in a project that has a present value of $400 million with an
exercise price (in year 2) of $600 million. Calculate the value of the option given that N(d1) = 0.6 and N(d2)
= 0.4. Assume that the risk-free interest rate is 6% per year.

A. $26.4 million
B. zero
C. $239.59 million
D. $13.58 million

6. 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.

22-2
7. 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

8. 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

Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil
rig at a cost of $50 million (C0). The construction costs are expected to remain constant. The price of oil P
is $40/bbl., and extraction costs are $25/bbl. The rig can extract a quantity of oil, Q = 300,000 bbl. per year
forever. (For tractability, assume that all first-year production occurs at the end of the first year.) Assume
that the cost of capital and the risk-free rate are both 6% per year. (Ignore taxes.)

9. Calculate the NPV from investing today.

A. +40 million
B. +75 million
C. +25 million
D. +150 million

22-3
10. Suppose that the oil price is uncertain and can be either $60/bbl. or $30/bbl. next year with equal
probability. Calculate the expected NPV of the project if it is postponed by one year.

A. +50 million
B. -25 million
C. +59 million
D. +47 million

11. Suppose that the oil price is uncertain and can be $60/bbl. or $30/bbl. next year with equal probability.
Then the value of the option to postpone the project by one year equals:

A. +34 million
B. +25 million
C. +59 million
D. -13 million

12. 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.

13. A project is worth $15 million today without an abandonment option. Suppose the value of the project is
either $20 million one year from today (if product demand is high) or $10 million (if product demand is
low). It is possible to sell off the project for $13 million if product demand is low. Calculate the value of
the abandonment option if the discount rate is 5% per year.

A. $1.21
million
B. $2.86 million
C. $1.90 million
D. $1.64 million

22-4
14. A project is worth $12 million today without an abandonment option. Suppose the value of the project is
either $18 million one year from today (if product demand is high) or $8 million (if product demand is
low). It is possible to sell off the project for $10 million if product demand is low. Calculate the value of
the abandonment option if the discount rate is 5% per year.

A. $1.03 million
B. $0.88 million
C. $1.90 million
D. $5.14 million

15. The NPV of a new video game, Dexa 1, is -1.5M after discounting all expected cash flows. However, if
high demand in the market evolves, Dexa 2 is a possible follow-on opportunity in two years. In two years it
will cost 10M to start Dexa 2, which will produce 9M of cash flow in year 2. N(d1) = 0.5785 and N(d2) =
0.1755. The annual interest rate is 11% and equals the risk-free rate. What is the Dexa 1 APV?

A. $1.95
M
B. $1.30
M
C. $2.28 M
D. $2.80 M

16. Assume the following data for Project X: NPV of the project without abandonment: -$2 million;
abandonment option value: $4 million. Calculate the adjusted present value (APV) of the project.

A. -$2 million
B. -$4 million
C. +$2 million
D. +$4 million

17. 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

22-5
18. 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

19. 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.

20. 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.

21. 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.

22-6
22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

22-7
27. 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.

28. 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.

29. 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

30. 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.

22-8
31. 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.

32. Imagine that you are the producer of Harry Potter films. You are trying to decide whether to film the next
two Harry Potter movies at the same time. If you film them both at once, you can save money on
production costs, but you could lose a lot of money if the first one flops and no one goes to see the second
one. Specifically, if you film them both at once, it will cost a total of $300 million, but if you film them
separately, they will cost $200 million each. If the first one is successful, it will have revenues of $1 billion
and the second one will have revenues of $1.5 billion. If the first one fails, it will only have revenues of
$150 million and the second one will have revenues of only $50 million. If you decide to film them
separately and the first one flops, you don't have to film the second one. The first film has a 50% chance of
succeeding and a 50% chance of failing. Assume that all figures are given as present values (you do not
need to do any additional discounting). Should you film both of them now or film them separately? Why?

A. Film them together now as NPV = $1,050 million.

B. Film them separately as NPV = $1,125 million.
C. Film them separately as NPV = $1,025 million.
D. None of the options

33. You are considering making a "Hillary" action figure to capitalize on popular political fever. Production
will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present
value (PV)). If voters do not catch the political fever, you will only sell action figures worth $2 million (in
PV) as only loyal Democrats will buy. Each possibility has a 50% chance. However, before production
begins, you can conduct a marketing survey to determine which scenario will happen. The survey costs $1
million. Is it worth conducting the survey? Why?

A. Do not conduct the survey as the NPV without a survey = +$6 million.
B. Conduct the survey as the NPV with a survey = $6.5 million.
C. Do not conduct the survey as the NPV with a survey = $5 million.
D. Do not conduct the survey as the NPV with a survey = $4 million.

22-9
34. 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

35. The owner of a pro-football team expects the team to be worth either $270 million next year or $120
million, depending on whether or not she gets the city to build a new stadium. There is a 60% chance she
will get a new stadium. There is a buyer willing to pay $175 million for the team right now. However, the
buyer will keep his offer open—until the stadium issue is resolved—if offered some form of compensation.
Given a discount rate of 7%, how much should she be willing to pay the potential buyer for a one-year
option to sell the team (round to the nearest $1 million)?

A. 0
B. $21 million
C. $42 million
D. $55 million

36. 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.

True / False Questions

37. The option to make a follow-on investment is a put option.

True False

22-10
38. The option to expand is a type of financial option.

True False

39. The option to wait is a type of real option.

True False

40. In real options, the required investment is considered the exercise price.

True False

41. APV = NPV (without expansion option) + value of the expansion option.

True False

42. Adjusted present value of project (APV) = NPV (without abandonment option) + value of abandonment
option.

True False

43. The first step in a real options analysis is to value the underlying asset using the discounted cash-flow
(DCF) method.

True False

44. The binomial method can be used for most abandonment options.

True False

45. Real options analysis can be used to link project life to the performance of the project.

True False

46. Temporary abandonment is a very simple real option that allows the firm to stop a project temporarily until
conditions improve.

True False

47. An electric utility plant that can operate on either oil or natural gas is an example of flexibility in
production.

True False

48. The risk-neutral approach is an application of the certainty equivalent method.

True False

22-11
49. Real options cannot be valued using the risk-neutral method since real assets do not trade in a liquid market
where prices are readily observable and arbitrage opportunities are exploited immediately.

True False

50. In an acquisition, the target firm may demand compensation from the acquiring firm if the deal falls
through. The acquiring firm's compensation is for the payment of a form of a real call option.

True False

Short Answer Questions

51. What are the four main types of real options?

52. How can managers take advantage of real options? Briefly explain.

22-12
53. How does an option to wait or postpone a project add value to the project?

54. How does an abandonment option increase the value of a project?

55. Explain the main difference between the Black-Scholes formula and the binomial method. How does this
relate to real options analysis?

22-13
56. Briefly explain how abandonment value can be used to help determine project life.

57. Briefly explain how temporary abandonment can be thought of as a complex option.

58. Explain the difference between the value of a project and the value of real options associated with a
project.

22-14
59. Briefly explain the implied assumption when the risk-neutral method is used for valuing real options.

60. Briefly discuss three practical problems associated with real options analysis.

61. How does a large firm like Intel hold a natural real option on a new technology, whereas a smaller firm
would not have the same option if they owned the same technology?

22-15
 Chapter 22 Real Options Answer Key

Multiple Choice Questions

1. 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

Type: Easy

2. 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

Type: Easy

22-16
3. 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.

Type: Medium

4. A firm has a three-year real option to invest in a project that has a present value of $500 million with an
exercise price (in year 3) of $800 million. Calculate the value of the option given that N(d1) = 0.3 and
N(d2) = 0.15. Assume that the risk-free interest rate is 6% per year.

A. $30.00 million
B. $49.25 million
C. zero
D. $7.08 million

C = 500(0.3) - (0.15)(800)/(1.06^3) = 49.25.

Type: Medium

5. A firm has a two-year real option to invest in a project that has a present value of $400 million with an
exercise price (in year 2) of $600 million. Calculate the value of the option given that N(d1) = 0.6 and
N(d2) = 0.4. Assume that the risk-free interest rate is 6% per year.

A. $26.4 million
B. zero
C. $239.59 million
D. $13.58 million

C = 400(0.6) - (0.4)(600)/(1.06^2) = 26.4.

Type: Medium

22-17
6. 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.

Type: Medium

7. 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

Type: Easy

8. 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

Type: Difficult

22-18
 Petroleum Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea
oil rig at a cost of $50 million (C0). The construction costs are expected to remain constant. The price of
oil P is $40/bbl., and extraction costs are $25/bbl. The rig can extract a quantity of oil, Q = 300,000 bbl.
per year forever. (For tractability, assume that all first-year production occurs at the end of the first
year.) Assume that the cost of capital and the risk-free rate are both 6% per year. (Ignore taxes.)

9. Calculate the NPV from investing today.

A. +40 million
B. +75 million
C. +25 million
D. +150 million

NPVtoday = [(40 - 25)(300,000)]/(0.06) - 50,000,000 = + 25,000,000 = 25 million.

Type: Difficult

10. Suppose that the oil price is uncertain and can be either $60/bbl. or $30/bbl. next year with equal
probability. Calculate the expected NPV of the project if it is postponed by one year.

A. +50 million
B. -25 million
C. +59 million
D. +47 million

In one year, we have:

NPV(oil price = $60/bbl.) = (60 - 25)(300,000)/0.06 - 50,000,000 = + 125,000,000;
NPV(oil price = $30/bbl.) = (30 - 25)(300,000)/0.06 - 50,000,000 = - 25,000,000 (reject);
NPV(oil price = $30/bbl.) = 0. (We only invest if the oil price next year is $60/bbl.);

Expected NPV = [(0.5) (0) + (0.5) (125,000,000)]/1.06 = 62,500,000/1.06 = $59 million.

Type: Difficult

22-19
11. Suppose that the oil price is uncertain and can be $60/bbl. or $30/bbl. next year with equal probability.
Then the value of the option to postpone the project by one year equals:

A. +34 million
B. +25 million
C. +59 million
D. -13 million

Value of the option to wait = 59 - 25 = $34 million.

Type: Difficult

12. 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.

Type: Easy

13. A project is worth $15 million today without an abandonment option. Suppose the value of the project is
either $20 million one year from today (if product demand is high) or $10 million (if product demand is
low). It is possible to sell off the project for $13 million if product demand is low. Calculate the value of
the abandonment option if the discount rate is 5% per year.

A. $1.21
million
B. $2.86 million
C. $1.90 million
D. $1.64 million

Risk-neutral valuation: Probability of high demand value = (interest rate - % downside change)/(upside
change - % downside change); [0.05 - (-5/15)]/[(5/15) - (-5/15)] = 0.575;
Probability of low demand value = 1-0.575 = 0.425;
Put option value = [(0.425)(13-10) + (0.575)(0)]/(1.05) = $1.2143.

Type: Difficult

22-20
14. A project is worth $12 million today without an abandonment option. Suppose the value of the project is
either $18 million one year from today (if product demand is high) or $8 million (if product demand is
low). It is possible to sell off the project for $10 million if product demand is low. Calculate the value of
the abandonment option if the discount rate is 5% per year.

A. $1.03 million
B. $0.88 million
C. $1.90 million
D. $5.14 million

12 = [(18)(X) + (8)(1 - X)]/1.05; X = 0.46; (1 - X) = 0.54; P = (2)(0.54)/1.05 = 1.03.

Type: Difficult

15. The NPV of a new video game, Dexa 1, is -1.5M after discounting all expected cash flows. However, if
high demand in the market evolves, Dexa 2 is a possible follow-on opportunity in two years. In two
years it will cost 10M to start Dexa 2, which will produce 9M of cash flow in year 2. N(d1) = 0.5785 and
N(d2) = 0.1755. The annual interest rate is 11% and equals the risk-free rate. What is the Dexa 1 APV?

A. $1.95
M
B. $1.30
M
C. $2.28 M
D. $2.80 M

APV = [base-case NPV] + [value of follow-on investment option];

Call Value = [N(d1) × (9/1.11^2)] - [N(d2) × (10/1.11^2)];
Call Value = [0.5785 × 7.3] - [.1755 × 8.12] = 2.8;
APV = -1.5 + 2.8 = +1.3.

Type: Medium

22-21
16. Assume the following data for Project X: NPV of the project without abandonment: -$2 million;
abandonment option value: $4 million. Calculate the adjusted present value (APV) of the project.

A. -$2 million
B. -$4 million
C. +$2 million
D. +$4 million

APV = -2 + 4 = +2.

Type: Easy

17. 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

Type: Easy

18. 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

Type: Difficult

22-22
19. 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.

Type: Difficult

20. 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.

Type: Medium

21. 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.

Type: Medium

22. 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.

Type: Medium

22-23
23. 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.

Type: Medium

24. 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.

Type: Medium

25. 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.

Type: Medium

26. 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.

Type: Medium

22-24
27. 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.

Type: Medium

28. 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.

Type: Medium

29. 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

Type: Difficult

22-25
30. 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.

Type: Medium

31. 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.

Type: Difficult

32. Imagine that you are the producer of Harry Potter films. You are trying to decide whether to film the
next two Harry Potter movies at the same time. If you film them both at once, you can save money on
production costs, but you could lose a lot of money if the first one flops and no one goes to see the
second one. Specifically, if you film them both at once, it will cost a total of $300 million, but if you
film them separately, they will cost $200 million each. If the first one is successful, it will have revenues
of $1 billion and the second one will have revenues of $1.5 billion. If the first one fails, it will only have
revenues of $150 million and the second one will have revenues of only $50 million. If you decide to
film them separately and the first one flops, you don't have to film the second one. The first film has a
50% chance of succeeding and a 50% chance of failing. Assume that all figures are given as present
values (you do not need to do any additional discounting). Should you film both of them now or film
them separately? Why?

A. Film them together now as NPV = $1,050 million.

B. Film them separately as NPV = $1,125 million.
C. Film them separately as NPV = $1,025 million.
D. None of the options

NPV(filming together) = -300 + (0.5)(1,000 + 1,500) + (0.5)(200) = $1,050 million;

NPV(film separately) = -200 + (0.5)(1,000 - 200 + 1500) + 0.5(150) = $1025 million.

Type: Difficult

22-26
33. You are considering making a "Hillary" action figure to capitalize on popular political fever. Production
will cost $5 million. If political fever strikes, you will sell action figures worth $20 million (in present
value (PV)). If voters do not catch the political fever, you will only sell action figures worth $2 million
(in PV) as only loyal Democrats will buy. Each possibility has a 50% chance. However, before
production begins, you can conduct a marketing survey to determine which scenario will happen. The
survey costs $1 million. Is it worth conducting the survey? Why?

A. Do not conduct the survey as the NPV without a survey = +$6 million.
B. Conduct the survey as the NPV with a survey = $6.5 million.
C. Do not conduct the survey as the NPV with a survey = $5 million.
D. Do not conduct the survey as the NPV with a survey = $4 million.

NPV without survey = -5 + (0.5)(20) + (0.5)(2) = +$6 million;

NPV with survey = -1 + (0.5)( - 5 + 20) + (0.5)(0) = +6.5 million.

Type: Difficult

34. 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

Type: Medium

22-27
35. The owner of a pro-football team expects the team to be worth either $270 million next year or $120
million, depending on whether or not she gets the city to build a new stadium. There is a 60% chance
she will get a new stadium. There is a buyer willing to pay $175 million for the team right now.
However, the buyer will keep his offer open—until the stadium issue is resolved—if offered some form
of compensation. Given a discount rate of 7%, how much should she be willing to pay the potential
buyer for a one-year option to sell the team (round to the nearest $1 million)?

A. 0
B. $21 million
C. $42 million
D. $55 million

The value of the team without the option is a binomial calculation.

Put option value = a one-year option to sell the team = [(0.6 × 0) + (0.4 × (175 - 120))]/1.07 = 20.56.

Type: Difficult

36. 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.

Type: Medium

True / False Questions

37. The option to make a follow-on investment is a put option.

FALSE

Type: Medium

38. The option to expand is a type of financial option.

FALSE

Type: Easy

22-28
39. The option to wait is a type of real option.

TRUE

Type: Medium

40. In real options, the required investment is considered the exercise price.

TRUE

Type: Medium

41. APV = NPV (without expansion option) + value of the expansion option.

TRUE

Type: Easy

42. Adjusted present value of project (APV) = NPV (without abandonment option) + value of abandonment
option.

TRUE

Type: Easy

43. The first step in a real options analysis is to value the underlying asset using the discounted cash-flow
(DCF) method.

TRUE

Type: Medium

44. The binomial method can be used for most abandonment options.

TRUE

Type: Medium

45. Real options analysis can be used to link project life to the performance of the project.

TRUE

Type: Medium

22-29
46. Temporary abandonment is a very simple real option that allows the firm to stop a project temporarily
until conditions improve.

FALSE

Type: Medium

47. An electric utility plant that can operate on either oil or natural gas is an example of flexibility in
production.

TRUE

Type: Easy

48. The risk-neutral approach is an application of the certainty equivalent method.

TRUE

Type: Medium

49. Real options cannot be valued using the risk-neutral method since real assets do not trade in a liquid
market where prices are readily observable and arbitrage opportunities are exploited immediately.

FALSE

Type: Medium

50. In an acquisition, the target firm may demand compensation from the acquiring firm if the deal falls
through. The acquiring firm's compensation is for the payment of a form of a real call option.

TRUE

Type: Difficult

Short Answer Questions

22-30
51. What are the four main types of real options?

I) The option to expand if the immediate investment project is a success

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

Type: Medium

52. How can managers take advantage of real options? Briefly explain.

Managers are not passive onlookers in a firm. They can make decisions to capitalize on good fortunes or
to mitigate losses. By adding flexibility to the firm's investments and operations decisions, managers
can create real options and thereby add value to the firm.

Type: Medium

53. How does an option to wait or postpone a project add value to the project?

The option to wait or postpone a project is equivalent to owning a call option on the investment project.
The option is exercised when the firm invests in the project. It is often preferable to defer the project in
order to keep the call alive. Deferral is most attractive when uncertainty is large. Hence the value of the
project is increased by the presence of the real option.

Type: Medium

54. How does an abandonment option increase the value of a project?

The option to abandon a project, a put option, provides partial insurance against failure and hence
increases the value of a project.

Type: Easy

22-31
55. Explain the main difference between the Black-Scholes formula and the binomial method. How does
this relate to real options analysis?

The Black-Scholes formula is a continuous time model whereas the binomial method uses discrete time
intervals. Therefore the binomial method is more useful for evaluating real options. The binomial
approach converges to the Black-Scholes method when the time interval is very small. Also u (1 + up%)
is equal to (e^σ√h), where σ is the standard deviation per year and h is the time interval as a fraction of a
year. (1 + down %) is 1/u. These relationships are used to switch between the Black-Scholes formula
and the binomial model.

Type: Medium

56. Briefly explain how abandonment value can be used to help determine project life.

Most projects' economic lives are not known at the start. In standard DCF capital-budgeting analysis,
the life of the project is fixed arbitrarily. For example, cash flows from a new product may last only for
a year or less if the product fails in the marketplace. But if the product is successful, then the product or
its variations or improvements could be produced for very many years. Real options analysis allows us
to arrive at the project's life using financial logic. Here we forecast a range of possible cash flows well
beyond the best guess of the project's economic life. Then the value of the project, including its
abandonment value, is used, in the best upside scenarios and also in the worst downside scenarios, to
analyze the life of the project. This procedure links project life to the performance of the project and
does not impose an arbitrary ending date.

Type: Medium

57. Briefly explain how temporary abandonment can be thought of as a complex option.

Firms often face situations that allow them to abandon a project temporarily until conditions improve.
However, a project cannot be turned on and off without cost. There is a fixed cost to temporarily
stopping a project. Unless you are sure that adverse economic conditions will persist, you do not want to
incur the fixed cost of a temporary shutdown. Similarly, you do not want to restart a temporarily
abandoned project unless you are sure that improved conditions will persist. There are a range of values
between which abandonment and restart occur. Beyond this range either the project is running or the
abandoned project remains abandoned. These can be thought of as complex options.

Type: Medium

22-32
58. Explain the difference between the value of a project and the value of real options associated with a
project.

The value of a project is the present value of all the cash flows from a project. It is usually calculated
using a discounted cash-flow method. The value of a real option on the project comes from the
opportunity to change or modify the cash flow from the project.

Type: Difficult

59. Briefly explain the implied assumption when the risk-neutral method is used for valuing real options.

When the risk-neutral method is used to value a real option, we implicitly assume that these options are
traded in an efficient market. The risk-neutral method gives option values as though the underlying asset
were traded in an efficient market. Conceptually, however, risk-neutral valuation is the same as the
certainty equivalent method.

Type: Medium

60. Briefly discuss three practical problems associated with real options analysis.

I) Real options can be complex, and valuing them may be difficult and time consuming.
II) Real options analysis applications to practical problems may be unstructured and solving these
problems can get complicated quickly.
III) Analyzing the real options applications when competitive firms can alter project payoffs may
require the use of game theory.

Type: Difficult

22-33
61. How does a large firm like Intel hold a natural real option on a new technology, whereas a smaller firm
would not have the same option if they owned the same technology?

The ability to commercialize a new technology is not the same for all firms. A company like Intel has
research, development, production, and distribution capability not possessed by smaller firms. The
option to make a follow-up investment and produce a significant profit, therefore, is an option that
maybe unique to Intel and not a smaller firm. Thus, new technology may be worth more to Intel than a
smaller competitor.

Type: Difficult

22-34