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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“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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 Spring '09
 abandonment option

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