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Chapter 13 - EOC Solutions

Chapter 13 - EOC Solutions - 131 a belowerthanexpected. ,

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Answers to End-of-Chapter Questions 13-1 a. An abandonment option is the option to abandoning a project if operating cash flows turn out to  be lower than expected.  This option can both raise expected profitability and lower project risk,  because in the case of poor cash flows, the project can be ended and rather than continue  realizing negative cash flows, fixed assets are sold and some cash is recovered. b. An investment timing option occurs when a firm has the option of delaying the start of a project  until additional information can be obtained.  After the delay, if conditions for the project look  unfavorable, the project will not be undertaken, while if conditions are favorable then the project  proceeds as usual.  However, there are some drawbacks to relying on investment timing  options.  First, the timing option should raise NPV because the probability of bad returns is less,  but that NPV needs to be discounted back one additional year.  Second, there might be  valuable “first mover” advantages to a project that will be lost if the project is delayed a year. c. Growth options exist if an investment creates the opportunity to make other potentially profitable  investments that would not otherwise be possible.  A common example of a growth option  occurs when a firm starts a project in a new country or market.  While the project is hoped to  add value from its cash flows, it also has value because it opens the door to the firm to operate  in the new country/market. d. Flexibility options permit the firm to alter operations depending on how conditions change  during the project’s life.  Typically, inputs, outputs, or both can be changed easily to respond to  market demands.  For example, instead of building an auto factory that builds a specific type of  car (compact, SUV, etc.), a manufacturer can build a factory that allows the building of many  types of cars.  Therefore, as market demand and consumer tastes change the firm can rapidly  respond. 13-2 Failure to recognize a growth option implies that a project with a negative conventional NPV was  rejected despite having an embedded growth option whose consideration would cause the NPV to  be positive.  As a result, failure to recognize the value of a growth option implies that the capital  budget is below the optimal level since a value-adding project (albeit because of a real option) has  been rejected.  This argument holds when considering failure to recognize all real options.
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