Deck 22: Real Options

Question 1

Which of the following statements is FALSE?

A)One way to see why you sometimes choose not to invest in a positive-NPV project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1)invest today or (2)wait.
B)You invest today only when the NPV of investing today exceeds the value of the option of waiting,which from option pricing theory we know to be always positive.
C)When you do not have the option to wait,it is optimal to invest in any positive-NPV project.
D)When you have the option of deciding when to invest,it is usually optimal to invest only when the NPV is positive but close to zero.

Answer 1

When you have the option of deciding when to invest,it is usually optimal to invest only when the NPV is positive but close to zero.

Question 2

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.Assuming that the probability of high or low demand is still 50%,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A)$0.
B)$90,000.
C)-$45,000.
D)$1,000,000.

Answer 2

$0.

Question 3

Which of the following statements is FALSE?

A)An alternative to using the Black-Scholes formula is to compute the value of growth options using risk-neutral probabilities.
B)Future growth options are not only important to firm value,but can also be important in the value of an individual project.
C)While the Black-Scholes formula values American options,most growth options cannot be exercised at any time.
D)Out-of-the-money calls are riskier than in-the-money calls,and because most growth options are likely to be out-of-the-money,the growth component of firm value is likely to be riskier than the ongoing assets of the firm.

Answer 3

While the Black-Scholes formula values American options,most growth options cannot be exercised at any time.

Question 4

Which of the following statements is FALSE?

A)Decision nodes are nodes in which uncertainty is involved that is out of the control of the decision maker.
B)Most investment projects allow for the possibility of reevaluating the decision to invest at a later point in time.
C)A decision tree is a graphical representation of future decisions and uncertainty resolution.
D)With binomial trees the uncertainty is not under the control of the decision maker.

Question 5

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately and that the probability of high or low demand would still be 50%.What is the value of the option to do pilot production and test marketing?

Question 6

Which of the following statements is FALSE?

A)Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.
B)Corporate bonds often contain embedded abandonment options: The issuing firm sometimes has the option to convert the bond-that is,to repay it.
C)An abandonment option is the option to walk away.
D)An important abandonment option that many people encounter at some point in their lives is the option to abandon their mortgage.

Question 7

Which of the following statements is FALSE?

A)In particular,because real options allow a decision maker to choose the most attractive alternative after new information has been learned,the presence of real options adds value to an investment opportunity.
B)To make an investment decision correctly,the value of embedded real options must be included in the decision-making process.
C)A key distinction between a real option and a financial option is that real options,and the underlying assets on which they are based,are often traded in competitive markets.
D)We can compute the value of the real option by comparing the expected profit without the real option to the value with the option.

Question 8

Luther Industries is considering launching a new toy just in time for the Christmas season.They estimate that if Luther launches the new toy this year it will have an NPV of $25 million.Luther has the option to wait one year until the next Christmas season to launch the toy,however,the demand next year will depend upon what new toys Luther's competitors introduce and therefore greater uncertainty about next year's demand.Launching the new toy today will involve a total capital expenditure of $100 million.If the risk-free rate is 5%,N(d1)is .62 and N(d2)is .65,then what is the value of the option to wait until next year to launch the new toy?

Question 9

Describe the two factors that affect the value of an investment timing option?

Question 10

Which of the following is NOT a real option?

A)A stock option
B)An abandonment option
C)An investment timing option
D)An expansion option

Question 11

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A)-$45,000.
B)$455,000.
C)$590,000.
D)$90,000.

Question 12

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.Further assume that the probability of high or low demand is still 50%.Draw a decision tree that details Kinston Industries Mountain Bike project if Kinston goes ahead and builds the plant immediately.

Question 13

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assuming that Kinston has the ability to sell the prototype in year one for $300,000,draw a decision tree detailing the Kinston Industries Mountain Bike Project.

Question 14

Which of the following statements is FALSE?

A)If there is a lot of uncertainty,the benefit of waiting is diminished.
B)In the real option context,the dividends correspond to any value from the investment that we give up by waiting.
C)By delaying an investment,we can base our decision on additional information.
D)Given the option to wait,an investment that currently has a negative NPV can have a positive value.

Question 15

The two different types of node on a decision tree are:

A)information and decision nodes.
B)information and uncertainty nodes.
C)uncertainty and decision nodes.
D)go to meet and stay home nodes.

Question 16

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assuming that Kinston has the ability to sell the prototype in year one for $300,000,the NPV of the Kinston Industries Mountain Bike Project is closest to:

A)$90,000.
B)$590,000.
C)$455,000.
D)-$45,000.

Question 17

Use the information for the question(s)below.
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing.The pilot production and test marketing phase will last for one year and cost $500,000.Your management team believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike.If the test-marketing phase is successful,then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after-tax cash flows of $400,000 in perpetuity beginning in year two.If the test marketing is not successful,Kinston can still go ahead and build the new plant,but the expected annual after-tax cash flows would be only $200,000 in perpetuity beginning in year two.Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000.Kinston's cost of capital is 10%.
Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000,draw a decision tree detailing the Kinston Industries Mountain Bike Project.

Question 18

Which of the following statements is FALSE?

A)Aside from the current NPV of the investment,other factors affect the value of an investment and the decision to wait.
B)The option to wait is most valuable when there is a great deal of uncertainty regarding what the value of the investment will be in the future.
C)The smaller the cost of waiting,the less attractive the option to delay becomes.
D)It is always better to wait to invest unless there is a cost to doing so.

Question 19

Unicorn Medical Devices is developing a new technology.After initial development of the device,the company must test it.If the tests go well and the device is successful,it can be marketed immediately.If the tests do not go well,Unicorn will revise the original device and repeat the process.The outcome of the tests is on a(n)________ in a decision tree.

A)decision node
B)information node
C)either node;it does not matter
D)This question cannot be answered without a graphical representation of the decision tree.

Question 20

Which of the following statements is FALSE?

A)It is tempting to use the Black-Scholes formula to value future growth options,but often there are good reasons why this formula might not price these options correctly.
B)When a firm has a real option to invest in the future it is known as a growth option.
C)Because growth options have value,they contribute to the value of any firm that has future possible investment opportunities.
D)Future growth opportunities can be thought of as a collection of real put options on potential projects.

Question 21

Which of the following statements is FALSE?

A)Traditionally,managers have used the equivalent annual benefit method to choose between projects of different lives.
B)The equivalent annual benefit method ignores the value of any real options because it assumes that the projects will always be replaced at their original terms.
C)If the future costs (or benefits)are certain with mutually exclusive projects,then we must use a real options approach to determine the correct decision.
D)The equivalent annual benefit method accounts for the difference in project lengths by calculating the constant payment over the life of the project that is equivalent to receiving the NPV today and then selecting the project with the higher equivalent annual benefit.

Question 22

Use the table for the question(s)below.
Consider the following mutually exclusive projects:
The NPV of project A is closest to:

A)$21.70.
B)$24.00.
C)$18.10.
D)$16.90.

Question 23

Use the table for the question(s)below.
Consider the following mutually exclusive projects:
The NPV of project B is closest to:

A)$18.10.
B)$21.70.
C)$24.00.
D)$16.90.

Question 24

Use the table for the question(s)below.
Consider the following mutually exclusive projects:
The equivalent annual benefit of project B is closest to:

A)$5.05.
B)$5.75.
C)$3.45.
D)$3.40.

Question 25

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Assuming you are able to sell the plant,draw a decision tree detailing this problem.

Question 26

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Assume that it will cost $1 million to shut down the plant,but you are able to sell the plant for $5 million at any time.The value of the option to sell the plant will be closest to:

A)$3.0 million.
B)$6.0 million.
C)$5.0 million.
D)$0.5 million.

Question 27

Assume the NPV of a project is $1.5 million.The project is expected to last five years.What is the equivalent annual benefit if the discount rate is 8%?

A)$375,685
B)$300,000
C)$347,856
D)$324,000

Question 28

The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the:

A)annualized annuity.
B)independent annual benefit.
C)equivalent annual profitability.
D)equivalent annual benefit.

Question 29

Which of the following statements is FALSE?

A)Often,the decision to abandon a project entails costs,which may be either positive or negative.
B)Mortgage interest rates are higher than Treasury rates because mortgages have an abandonment option that Treasuries do not have: You can prepay your mortgage at any time,while the U.S.government can repay its debt only according to the schedule outlined in the bond contract.
C)A popular option gives holders of the bond the option to convert the bond into equity.These kinds of bonds are termed callable bonds.
D)More often than not,there is an opportunity cost of abandoning a project: If you shut down the project and later decide to start it up again,you have to pay the costs of restarting the project.

Question 30

Rylan Inc is considering a project that has an initial cost of $2 million.It is expected to generate cash flows for the firm of $500,000 per year for 6 years.Assuming a discount rate of 7%,what is the equivalent annual benefit?

A)$75,148
B)$80,408
C)$85,889
D)$91,901

Question 31

Use the table for the question(s)below.
Consider the following mutually exclusive projects:
Using the equivalent annual benefit method,which project would you select and why?

Question 32

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Assume that you are not able to sell the plant,but you are able to shut down the plant at no cost at any time.The value of the option to abandon production will be closest to:

A)$1.0 million.
B)$0.5 million.
C)-$1.0 million.
D)$3.0 million.

Question 33

Use the table for the question(s)below.
Consider the following mutually exclusive projects:
The equivalent annual benefit of project A is closest to:

A)$21.70.
B)$5.05.
C)$24.00.
D)$3.40.

Question 34

The idea that after making a large investment,a manager should not abandon the project is known as the:

A)negative NPV fallacy.
B)abandonment fallacy.
C)sunk cost fallacy.
D)dependence fallacy.

Question 35

When the value of one project depends on the outcome of one or more other projects,this is known as:

A)mutually independent investments.
B)equivalent annual investments.
C)staged dependent investments.
D)mutually dependent investments.

Question 36

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
If you are not awarded the government contract and your sales decrease by 25%,then the value of your plant will be closest to:

A)-$1 million.
B)$5 million.
C)$8 million.
D)$0.

Question 37

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Assume that you are not able to sell the plant,but you are able to shut down the plant at no cost at any time.Given the embedded option to abandon production,the value of your plant will be closest to:

A)$8.0 million.
B)$4.0 million.
C)$5.0 million.
D)$6.5 million.

Question 38

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Assume that you are not able to sell the plant,but you are able to shut down the plant,at no cost,at any time.Draw a decision tree detailing this problem.

Question 39

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
If you are awarded the government contract and your sales increase by 20%,then the value of your plant will be closest to:

A)$5 million.
B)$8 million.
C)$0.
D)$4 million.

Question 40

Use the information for the question(s)below.
You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
Given the embedded option to sell the plant,the value of your plant will be closest to:

A)$5.0 million.
B)$4.0 million.
C)$6.5 million.
D)$8.0 million.

Question 41

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $80,000,Rearden should:

A)invest today since the NPV is positive.
B)invest today since the NPV is negative.
C)invest today since the NPV using the hurdle rate is positive.
D)delay investing since the NPV using the hurdle rate is negative.
E)delay investing since the NPV using the hurdle rate is positive.

Question 42

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,the NPV of investing in the project today using the hurdle rate is closest to:

A)-$281,000.
B)-$150,000.
C)-$83,000.
D)+$83,000.
E)+$281,000.

Question 43

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,Rearden should:

A)invest today since the NPV is positive.
B)invest today since the NPV is negative.
C)invest today since the NPV using the hurdle rate is negative.
D)delay investing since the NPV using the hurdle rate is negative.
E)delay investing since the NPV using the hurdle rate is positive.

Question 44

The rate on a risk-free annuity that can be called at any time is known as the:

A)callable annuity rate.
B)callable auction rate.
C)callable hurdle rate.
D)risk-free rate.

Question 45

Which of the following statements is FALSE?

A)When the investment cannot be delayed,the optimal rule is to invest whenever the profitability index is greater than zero.
B)It is often better to wait too long (use a profitability index criterion that is too high)than to invest too soon (use a profitability index criterion that is too low).
C)When the source of uncertainty that creates a motive to wait is interest rate uncertainty,the hurdle rate is relatively easy to calculate.
D)When there is an option to delay,a good rule of thumb is to invest only when the profitability index is at least 1.

Question 46

The callable annuity rate can be calculated as:

A) × Hurdle Rate.
B) × Hurdle Rate.
C) × Cost of Capital.
D) .

Question 47

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000,the NPV of investing in the project next year is closest to:

A)-$281,000.
B)+$46,000.
C)+$83,000.
D)+$143,000.
E)+$238,000.

Question 48

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,the NPV of investing in the project next year is closest to:

A)-$281,000.
B)-$83,000.
C)+$46,000.
D)+$83,000.
E)+$143,000.

Question 49

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000,and using the hurdle rate,Rearden should:

A)invest today since the NPV is positive.
B)invest today since the NPV is negative.
C)invest today since the NPV using the hurdle rate is positive.
D)delay investing since the NPV using the hurdle rate is negative.
E)delay investing since the NPV using the hurdle rate is positive.

Question 50

Mutually dependent investments occur when:

A)the value of one project depends upon the outcome of one or other projects.
B)the value of one project is independent of any other projects.
C)a firm depends on another firm to provide materials for a project.
D)consumers and producers depend on each other's investments.

Question 51

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $80,000,the NPV of investing in the project today using the hurdle rate is closest to:

A)-$281,000
B)+$46,000
C)+$83,000
D)+$143,000
E)+$238,000

Question 52

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000,the NPV of investing in the project today is closest to:

A)-$281,000.
B)-$83,000.
C)+$46,000.
D)+$83,000.
E)+$143,000.

Question 53

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $55,000,the NPV of investing in the project today is closest to:

A)-$281,000.
B)-$150,000.
C)-$83,000.
D)+$83,000.
E)+$281,000

Question 54

Use the information for the question(s)below.
DM Skateboard company is planning to develop a new electric skateboard.In order for the project to be successful,the company must develop a new deck to accommodate a lightweight battery and a remote that is easy to operate while moving in an open environment.The company estimates the following costs,times,and probabilities of success for each component of the new skateboard: All three risks are idiosyncratic and the risk-free rate of interest is 5%.The company does not have the resources to develop all the components at the same time.Therefore,management needs to decide in what order to develop the technologies.
What is the failure cost index of the battery technology?

A)0.00375
B)0.00392
C)0.99875
D)0.99892

Question 55

Which of the following statements is FALSE?

A)The profitability index rule of thumb raises the bar on the NPV to take into account the option to wait.
B)In practice,correctly modeling the sources of uncertainty and the appropriate dynamic decisions usually requires an extensive amount of time and financial expertise.
C)Some firms use the following rule of thumb: Invest whenever the profitability index is below a specified level.
D)Instead of raising the bar on the NPV,the hurdle rate rule raises the discount rate.

Question 56

Which of the following statements is FALSE?

A)The hurdle rate rule for projects with the option to delay uses a lower discount rate than the cost of capital to compute the NPV,but then applies the regular NPV rule: Invest whenever the NPV calculated using this lower discount rate is positive.
B)While using a hurdle rate rule for deciding when to invest might be a cost-effective way to make investment decisions,it is important to remember that this rule does not provide an accurate measure of value.
C)When the cash flows are constant and perpetual,and the reason to wait derives solely from interest rate uncertainty,the hurdle rate rule of thumb is always exact.However,when these conditions are not satisfied,the rule of thumb merely approximates the correct decision.
D)When a firm faces the same uncertainty for most of its investment decisions,using a single profitability index criterion for all projects can provide a useful rule of thumb to account for cash flow uncertainty.

Question 57

Use the information for the question(s)below.
DM Skateboard company is planning to develop a new electric skateboard.In order for the project to be successful,the company must develop a new deck to accommodate a lightweight battery and a remote that is easy to operate while moving in an open environment.The company estimates the following costs,times,and probabilities of success for each component of the new skateboard: All three risks are idiosyncratic and the risk-free rate of interest is 5%.The company does not have the resources to develop all the components at the same time.Therefore,management needs to decide in what order to develop the technologies.
Assume DM Skateboard Company has estimated that,if all stages are successful,the present value of all future profits will be $4 million (valued at the completion of all three phases of development).If DM does the three stages in the correct order,what is the NPV of the project?

A)$128.13 thousand
B)-$34.50 thousand
C)$65.18 thousand
D)$3.79 million

Question 58

Use the information for the question(s)below.
DM Skateboard company is planning to develop a new electric skateboard.In order for the project to be successful,the company must develop a new deck to accommodate a lightweight battery and a remote that is easy to operate while moving in an open environment.The company estimates the following costs,times,and probabilities of success for each component of the new skateboard: All three risks are idiosyncratic and the risk-free rate of interest is 5%.The company does not have the resources to develop all the components at the same time.Therefore,management needs to decide in what order to develop the technologies.
What is the failure cost index of the deck technology?

A)0.00500
B)0.98500
C)0.98536
D)0.00536

Question 59

Use the information for the question(s)below.
DM Skateboard company is planning to develop a new electric skateboard.In order for the project to be successful,the company must develop a new deck to accommodate a lightweight battery and a remote that is easy to operate while moving in an open environment.The company estimates the following costs,times,and probabilities of success for each component of the new skateboard: All three risks are idiosyncratic and the risk-free rate of interest is 5%.The company does not have the resources to develop all the components at the same time.Therefore,management needs to decide in what order to develop the technologies.
What is the failure cost index of the remote technology?

A)0.00200
B)0.99800
C)0.00210
D)0.99810

Question 60

Use the following information to answer the question(s)below.
Rearden Metal can invest in a risk-free technology that requires an up-front investment of $1 million.Rearden's managers are hesitant to invest because of uncertainty over future interest rates.Suppose that all interest rates will be either 8% or 4% in one year and remain there forever.The risk-neutral probability that interest rates will drop to 4% is 40%.The one-year risk-free interest rate is 5% and today's rate on a risk-free perpetual bond is 6%.The rate on an equivalent perpetual bond that is repayable at any time (the callable annuity rate)is 7.65%.
Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000,the NPV of investing in the project today using the hurdle rate is closest to:

A)-$281,000.
B)-$150,000.
C)-$83,000.
D)+$83,000.
E)+$281,000.

Question 61

The major principles to remember when considering real options include all of the following EXCEPT:

A)out-of-the-money real options have value.
B)in-the-money real options need to be exercised immediately.
C)waiting is valuable.
D)create value by exploiting real options.

Question 62

Which of the following is an example of a way in which companies can create value by exploiting real options?

A)Abandoning good projects in favor of newer projects
B)Acting quickly to take on new projects,even if there is no cost to waiting
C)Exercising in-the-money real options immediately
D)Optimally delaying or abandoning projects

Question 63

Do out-of-the-money real options have value?

Question 64

Can value can be created by waiting for uncertainty to resolve?