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Unformatted text preview: 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 projects 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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This note was uploaded on 02/11/2011 for the course FIN 3403 taught by Professor Tapley during the Spring '06 term at University of Florida.
- Spring '06