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Unformatted text preview: Chapter 13 Real Options ANSWERS TO END-OF-CHAPTER QUESTIONS 13-1 a. Real options occur when managers can influence the size and risk of a projects cash flows by taking different actions during the projects life. They are referred to as real options because they deal with real as opposed to financial assets. They are also called managerial options because they give opportunities to managers to respond to changing market conditions. Sometimes they are called strategic options because they often deal with strategic issues. Finally, they are also called embedded options because they are a part of another project. b. Investment timing options give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project. Capacity options allow a company to change the capacity of their output in response to changing market conditions. This includes the option to contract or expand production. Growth options allow a company to expand if market demand is higher than expected. This includes the opportunity to expand into different geographic markets and the opportunity to introduce complementary or second-generation products. It also includes the option to abandon a project if market conditions deteriorate too much. c. Decision trees are a form of scenario analysis in which different actions are taken in different scenarios. 13-2 Postponing the project means that cash flows come later rather than sooner; however, waiting may allow you to take advantage of changing conditions. It might make sense, however, to proceed today if there are important advantages to being the first competitor to enter a market. 13-3 Timing options make it less likely that a project will be accepted today. Often, if a firm can delay a decision, it can increase the expected NPV of a project. 13-4 Having the option to abandon a project makes it more likely that the project will be accepted today. Answers and Solutions: 13 - 1 SOLUTIONS TO END-OF-CHAPTER PROBLEMS 13-1 a. 0 1 2 20 -20 3 3 3 NPV = $1.074 million. b. Wait 1 year: PV @ 1 2 3 21 Yr. 1 Tax imposed | | | | | 50% Prob .-20 2.2 2.2 2.2 15.45 Tax not imposed | | | | | 50% Prob.-20 3.8 3.8 3.8 26.69 Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027 Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920 Expected NPV = .5(-4.027) + .5(5.920) = 0.947 Note though, that if the tax is imposed, the NPV of the project is negative and therefore would not be undertaken. The value of this option of waiting one year is evaluated as 0.5($0) + (0.5)($ 5.920) = $2.96 million....
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- Spring '10