Chapter 5

# Chapter 5 - Chapter 5 1 A What is the rationale for using...

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Chapter 5: 1. A) What is the rationale for using simulation? B) What are the steps to a simulation? Answer: A) The reason for using simulation is to evaluate strategic alternatives. B) The steps are: First : identify the strategies to be evaluated Second : establish the criteria for evaluating the alternatives Third : model the strategies by specifying the underlying determinants of revenue and cost Fourth : specify the assumptions and uncertainties that influence the value of each strategy (either identify an assumed value and support it, or identify a statistical process that will generate a value Fifth : run the simulation Sixth : analyze the results 2. In simulation, how does the abandonment option change the value of the venture? Answer: The abandonment option is equivalent to a put option with exercise price equal to the value obtained from selling the project. The exercise date is the date when uncertainly about the demand for the venture is reduced. The simulation model can be used to determine the expected present value of continuing to operate the venture. If this value is less than the exercise price of the abandonment option, the entrepreneur should exercise the option to abandon. You can modify the model to include the value of the abandon option as described above and run the simulation model. The resulting expected NPV should be compared to the NPV of the original model (excluding options). The difference in NPV is the value of the option.

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3. “Modeling the NPV of a venture as an abandonment option (at a low level of sales), and a capacity constraint (at a high level of sales), approximates the combination of three securities.” Explain using a graph. Answer:
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Chapter 5 - Chapter 5 1 A What is the rationale for using...

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