Ch.16 Real Options And Cross-Border – Complete Test Bank 6e

Chapter 16 Real Options and Cross-Border Investment Strategy

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. A real option is an option that is based on an underlying real (inflation-adjusted) price.

Options on real assets are called real options.

2. Option pricing methods suggest that managers immediately invest in real options with positive intrinsic values.

Managers will wait before investing in real options with positive time values.

3. Option pricing methods suggest that imposing higher hurdle rates on immediate investment in uncertain environments is irrational.

This may be a rational response to uncertainty when valuing real options.

4. Option pricing methods suggest that proper application of the NPV rule should consider when to invest and not just whether to invest.

5. Firms seldom remain in markets in which they are losing money.

Firms remain in unprofitable markets when abandonment or reentry costs are high.

6. Firms should never invest in emerging markets if the expected net present value—when viewed as a “now or never” alternative—is negative.

The time value of the option to invest may make up for a negative intrinsic value.

7. The decision to invest in a project today must be compared with the alternative of investing in the same or similar projects at some future date.

8. A part of the exercise price of the investment option is the forgone value from investing in a more attractive future project.

9. The intrinsic value of an option is its present value assuming markets are informationally efficient.

The intrinsic value of an option is the value of the option if exercised today.

10. The time value of an option is its value as of a particular future date.

The time value of an option reflects the fact that an option need not be exercised today.

11. As the value of the underlying asset increases, the value of a call option increases.

12. Option values increase with an increase in the volatility of the underlying asset, all else constant.

13. An increase in uncertainty regarding the price at which a firm can sell the output from a foreign investment project leads to an increase in the value of the investment, all else constant.

14 Firms demand higher hurdle rates in uncertain environments because of the option value of waiting for additional information.

15. The time value of a real option reflects managerial flexibility.

16. Uncertainty is endogenous when the act of investing reveals information about price or cost.

17. Uncertainty is exogenous when it is outside the firm’s control.

18. All else constant, exogenous uncertainty creates an incentive to postpone investment.

19. Exogenous uncertainty can create an incentive to speed up investment in order to gain more information about likely future prices and costs.

Exogenous uncertainty is outside the control of the corporation, and so investment cannot change the pace at which information arrives.

20. Real investment options gain value by avoiding bad times, whereas real abandonment options gain value by staying invested during good times.

21. The abandonment option is a form of put option.

22. Endogenous uncertainty creates an incentive to speed up investment in order to gain additional information and resolve the uncertainty.

23. Multinational corporations usually make incremental investments into emerging markets because of the intrinsic value of these real investment options.

When uncertainty is endogenous, incremental investment can provide management with additional information on which to base further investment decisions.

24. Hysteresis is the phenomenon in which firms fail to enter markets that appear attractive and, once invested, persist in operating at a loss.

25. Assets-in-place are those assets in which the firm has already invested.

26. The value of the firm’s growth options is reflected in the market value of equity.

27. The value of growth options typically is included in the firm’s reported financial statements.

Financial statements reflect historical costs and not future opportunities.

28. Discounted cash flow and option pricing approaches to project valuation are incompatible; when one approach is used, the other should not be used.

When used as a second opinion, the approaches are complements and can provide a more robust picture of the sources of value, the opportunities, and the risks.

29. Option values are always more volatile than the asset values on which they are based.

30. Returns on options are approximately normally distributed.

Returns on options are inherently nonnormal.

Multiple Choice Select the BEST ANSWER

1. An option with more than one source of uncertainty is called a(n) ____ option.

a. amorphous

b. complex

c. compound

d. rainbow

e. switching

2. Managerial divergence from the rule “accept all positive NPV projects” arises because ____.

a. managers’ objectives can differ from those of shareholders

b. of the presence of real options

c. the NPV decision rule is not designed to maximize shareholder wealth

d. three of the above

e. two of the above

3. Managerial actions can appear to be inconsistent with the NPV rule because ____.

a. managers are irrational

b. markets are inefficient

c. options on real assets are difficult to value with NPV

d. three of the above

e. two of the above

4. Real options include ____.

a. the expansion/contraction options

b. the investment/abandonment options

c. the suspension/reactivation options

d. three of the above

e. two of the above

5. The time value of an option to invest in a real asset reflects ____.

a. managerial flexibility in the timing of investment

b. the value of the asset as a “now or never” proposition

c. the value of the option to delay the project

d. three of the above

e. two of the above

6. The intrinsic value of an option to invest in a real asset reflects ____.

a. managerial flexibility in the timing of investment

b. the value of the asset as a “now or never” proposition

c. the value of the option to delay investment

d. three of the above

e. two of the above

7. The value of an option to invest in a real asset reflects ____.

a. managerial flexibility in the timing of investment

b. the value of the asset as a “now or never” proposition

c. the value of the option to delay investment

d. three of the above

e. two of the above

8. Firms continue to operate in unfavorable environments ____.

a. because the time value of the abandonment option is zero

b. to avoid the sunk costs of abandoning investment

c. when there is a chance that prospects will improve

d. three of the above

e. two of the above

9. Which of the following statements applies to hysteresis?

a. Hysteresis occurs when there are both high entry and exit costs.

b. Hysteresis refers to the hysteria of a currency crisis

c. Hysteresis is a consequence of the intrinsic value of a “now or never” proposition.

d. three of the above

e. two of the above

10. Call option values increase with ____.

a. an increase in the exercise price

b. an increase in the volatility of the underlying asset value

c. an increase in the systematic risk (beta) of the asset underlying the option

d. more than one of the above

e. none of the above

11. Call option values decrease with ____.

a. an increase in the underlying asset value

b. an increase in the volatility of the underlying asset value

c. an increase in the systematic risk (beta) of the asset underlying the option

d. more than one of the above

e. none of the above

12. Which of the following is ?

a. Options are always more volatile than the assets on which they are based.

b. Returns on options are inherently non-normal.

c. Returns on options are asymmetric.

d. The volatility of an option changes with changes in the value of the underlying asset.

e. Option pricing methods discount option payoffs at a risk-adjusted discount rate.

13. Financial options are easier to value than real options for each of the following reasons EXCEPT ____.

a. Exercise prices on financial options are contractually written on a single financial price that is readily observable in the financial market.

b. Markets for real assets have fewer imperfections than financial markets.

c. Real asset markets typically are less competitive than financial markets.

d. Each of the above is a reason why financial options are easier to value.

e. None of the above is a reason why financial options are easier to value.

14. Uncertainty that is outside the firm’s control is called ____ uncertainty.

a. amorphous

b. compound

c. endogenous

d. exogenous

e. foreign

Problems

PROBLEMS 1-4 ARE BASED ON EXHIBIT T16.1.

Exhibit T16.1

A proposed plant in China will process soybeans for the local (Chinese new yuan, or ¥) market. The sales price of a ton of processed soy will be determined by a government panel, and will be known with certainty in one year. The plant must decide whether to begin production today or in one year. The following facts apply to the investment decision.

Initial investment I₀ = ¥20,000,000 (rises at 10% per year)

Expected sales price per ton P₀ = ¥50,000 per ton in perpetuity

Actual price P₁ = either ¥40,000 or ¥60,000 with equal probability

Variable production cost VC = ¥40,000 per ton

Expected production Q = 500 tons per year forever

Tax rate T_C = 0%

Discount rate i = 10%

Exogenous price uncertainty and the option to invest.

1. Answer the following questions based on the information in Exhibit T16.1.

a. Draw a decision tree that depicts this investment decision.

b. Calculate the NPV of investing today as if it were a now-or-never alternative.

c. Calculate the NPV (at t = 0) of waiting one year before making a decision.

d. Decompose option value into intrinsic value and time value. Should this investment be made today, in one year, or not at all?

e. Suppose price will be either ¥70,000 or ¥30,000 with equal probability in one year. How does this increase in endogenous price uncertainty affect option value?

Endogenous price uncertainty and growth options.

2. The investment of Exhibit T16.1 is one of 10 soybean processing plants that could be constructed in various Chinese provinces. A government panel will set the price of processed soybeans once production begins. The government panel will not commit to a price until production begins in at least one of the plants. As of today, the investment situation of each plant is identical to that in Exhibit T16.1.

a. Draw a decision tree depicting the choice between immediate investment in all 10 plants and investment in a single plant with an option to expand investment in one year.

b. Calculate the NPV of investing today as if it were a now-or-never alternative.

c. Calculate the NPV (as of t = 0) of investing in a single plant (and hence revealing the government’s price) and then waiting one year before considering further investment.

d. Decompose option value into intrinsic value and time value. Should investment be made all at once, sequentially, or not at all?

e. Suppose price will be either ¥70,000 or ¥30,000 with equal probability in one year. How does this increase in exogenous price uncertainty affect option value?

Exogenous cost uncertainty and the option to invest.

3. Consider the investment opportunity in Exhibit T16.1. Suppose price will be ¥50,000 with certainty, but variable production cost will be either ¥30,000 or ¥50,000 with equal probability depending on the decision of a government panel that sets local wages.

a. Calculate the NPV of investing today as if it were a now-or-never alternative.

b. Calculate the NPV (at t = 0) of waiting one year before making a decision.

c. Decompose option value into intrinsic value and time value. Should this investment be made today, in one year, or not at all?

d. Suppose variable cost will be either ¥60,000 or ¥20,000 with equal probability in one year. How does this increase in endogenous cost uncertainty affect option value?

Exogenous price uncertainty and the option to abandon.

4. Management has gone ahead with the investment in Exhibit T16.1, but the market is very competitive and several competitors are considering abandoning the market. If they do not abandon, price will remain at the current level of ¥30,000/ton in perpetuity. It is equally likely that they will abandon, in which case the price will rise to ¥40,000/ton. Because of labor agreements, management must either produce at capacity or close the brewery, at a cost of ¥2 million. This abandonment cost rises at 10 percent per year. Assume the plant’s abandonment decision does not influence competitors’ abandonment decisions, so price uncertainty is exogenous. Other facts are as in Exhibit T16.1.

a. Draw a decision tree that depicts the abandonment decision.

b. Calculate the NPV of abandoning today as if it were a now-or-never alternative.

c. Calculate the NPV (as of t = 0) of waiting one year before making a decision.

d. Decompose option value into intrinsic value and time value. Should this investment be made today, in one year, or not at all?

e. Suppose price will be either ¥50,000 or ¥20,000 with equal probability in one year. How does this increase in endogenous price uncertainty affect option value?

Problem Solutions

1. a. Decision tree:

b. V(invest today) = [ (¥50,000/ton – ¥40,000/ton)(500 tons) / 0.10 ] – ¥20,000,000

= ¥30,000,000 ⇒ invest today?

c. V|(P₁ = ¥40,000) = [(¥40,000/ton – ¥40,000/ton)(500 tons)/0.10)/(1.10)] – ¥20,000,000

= ¥20,000,000 ⇒ don’t invest

V|(P₁ = ¥60,000) = [(¥60,000/ton – ¥40,000/ton)(500 tons)/0.10)/(1.10)] – ¥20,000,000

= ¥70,909,091 ⇒ invest

V(wait one year) = Prb(P₁ = ¥60,000)(NPV⏐P₁ = ¥60,000) + Prb(P₁ = ¥40,000)(NPV⏐P₁ = ¥40,000)

= (½)(¥70,909,091) + (½)(¥0) = ¥35,454,545 > NPV(invest today) > ¥0

d. Option Value = Intrinsic Value + Time Value

V(wait one year) = V(invest today) + Opportunity cost of investing today

¥35,454,545 = ¥30,000,000 + ¥5,454,545

The NPV of immediate investment is ¥30,000,000. This is ¥5,454,545 less than the NPV of waiting a year before deciding. This forgone time value of ¥5,454,545 is the opportunity cost of investing today. Wait one period before deciding to invest.

e. V(invest today) = ¥30,000,000 as in part b.

V|(P₁ = ¥30,000) < ¥0 ⇒ don’t invest

V|(P₁ = ¥70,000) = [(¥70,000/ton–¥40,000/ton)(500 tons) / 0.10) / (1.10)]

 ¥20,000,000 = ¥116,363,636 ⇒ invest

V(wait one year) = (½)(¥116,363,636) + (½)(¥0) = ¥58,181,818

This increase in exogenous uncertainty increases the value of the timing option by ¥22,727,273, from ¥35,454,545 to ¥58,181,818.

2. a. Decision tree:

b. At E[P₁] = ¥50,000/ton, the NPV of immediate investment in a single plant is

V(invest in one plant today) = [ (¥50,000/ton – ¥40,000/ton)(500 tons) / 0.10 ]  ¥20,000,000

= ¥30,000,000 ⇒ invest today?

V(invest in all 10 plants today) = (10) NPV(invest in one plant today) = ¥300,000,000

c. If management waits a year before making its decision, price will be either ¥40,000 or ¥60,000.

V|(P₁ = ¥40,000) = [(¥40,000/ton – ¥40,000/ton)(500 tons) / 0.10) / (1.10)]  ¥20,000,000

= ¥20,000,000 ⇒ don’t invest

V|(P₁ = ¥60,000) = [(¥60,000/ton – ¥40,000/ton)(500 tons) / 0.10) / (1.10)]  ¥20,000,000

= ¥70,909,091 ⇒ invest in 9 additional plants at time one.

V(wait one year) = [Prb(P₁ = ¥60,000)](V|P₁ = ¥60,000) + [Prb(P₁ = ¥40,000)](V|P₁ = ¥40,000)

= (½)[(¥70,909,091) + (9)(¥70,909,091)/(1.10)] + (½)(¥0) = ¥325,537,190 > V(invest today) > ¥0

d. Option Value = Intrinsic Value + Time Value = NPV(wait 1 year) = NPV(invest today) + Opportunity cost of 4 more breweries today = ¥325,537,190 = ¥300,000,000 + ¥25,537,190.

The ¥300,000,000 NPV of immediate investment is ¥25,537,190 less than the NPV of investing in one exploratory plant and then waiting one year before further investment. The forgone time value of ¥25,537,190 is the opportunity cost of investing in all 10 plants today. Invest in an exploratory plant today and continue to invest if warranted by the price of processed soybeans.

e. V(invest in all 10 plants today) = ¥300,000,000 as in part b.

V|(P₁ = ¥30,000) < ¥0 ⇒ don’t invest

V|(P₁ = ¥70,000) = [(¥70,000/ton – ¥40,000/ton)(500 tons)/0.10)/(1.10)]¥20,000,000 = ¥116,363,636

⇒ invest in 9 additional plants, providing value of (9)(¥116,363,636)/(1.10) = ¥952,066,116

V(wait one year) = (½)[(¥116,363,636) + ( ¥952,066,116)] + (½)(¥0) = ¥534,214,876

⇒ Value of timing option = ¥234,214,876

The opportunity cost of investing in all ten plants today increases with an increase in cost uncertainty. There is even more incentive to make a sequential investment.

3. a. V(invest today) = [ (¥50,000/ton – ¥40,000/ton)(500 tons)/0.10 ] ¥20,000,000

= ¥40,000,000 ⇒ invest today?

b. V|(C₁ = ¥50,000) = [(¥50,000/ton – ¥50,000/ton)(500 tons)/0.10)/(1.10)] ¥20,000,000

= ¥20,000,000 ⇒ don’t invest

V|(C₁ = ¥30,000) = [(¥50,000/ton – ¥30,000/ton)(500 tons) / 0.10) / (1.10)]  ¥20,000,000

= ¥70,909,091 ⇒ invest

V(wait one year) = (½)(¥70,909,091) + (½)(¥0) = ¥35,454,545 > ¥0

c. Option Value = Intrinsic Value + Time Value

V(wait one year) = V(invest today) + Opportunity cost of investing today

¥35,454,545 = ¥30,000,000 + ¥5,454,545

The NPV of immediate investment is ¥30,000,000. This is ¥5,454,545 less than the NPV of waiting one year before making the investment decision. This forgone time value of ¥5,454,545 is the opportunity cost of investing today. Wait one period before deciding.

d. V(invest today) = ¥30,000,000 as in part b.

V|(C₁ = ¥60,000) < ¥0 ⇒ don’t invest

V|(C₁ = ¥20,000) = [(¥50,000/ton–¥20,000/ton)(500 tons)/0.10)/(1.10)]  ¥20,000,000

= ¥116,363,636 ⇒ invest

NPV(wait one year) = (½)(¥116,363,636) + (½)(¥0) = ¥58,181,818. This increase in endogenous uncertainty increases the value of the timing option. In this case, the increase in value is ¥22,727,273 = ¥58,181,818 – ¥35,454,545.

4. a. Decision tree:

b. At E[P₁] = ¥35,000/ton, the NPV of the “abandon today” alternative is

V(abandon today) = –[((¥35,000/ton– ¥40,000/ton)(500 tons) / 0.10] – ¥2,000,000

= ¥23,000,000 > ¥0 ⇒ abandon today?

c. If management waits one year before making its abandonment decision, prices will be either ¥30.000 or ¥40,000 with certainty.

V|(P₁ = ¥40,000) = –[(((¥40,000/ton–¥40,000/ton)(500 tons)) / 0.10) / (1.10)] – ¥2,000,000

= –¥2,000,000 ⇒ don’t abandon if price rises to ¥40,000

V|(P₁ = ¥30,000) = –[(((¥30,000/ton–¥40,000/ton)(500 tons)) / 0.10) / (1.10)] – ¥2,000,000

= ¥43,454,545 ⇒ abandon if price falls to ¥30,000

V(wait one year) = [Prb(P₁ = ¥30,000)](V|P₁ = ¥30,000) + [Prb(P₁ = ¥40,000)](V|P₁ = ¥40,000)

= (½)(¥43,454,545) + (½)(¥0) = ¥21,727,273 > NPV(abandon today) > ¥0

1. Option Value = Intrinsic Value + Time Value

NPV(wait one year) = NPV(abandon today) + Opportunity cost of abandoning today

+ ¥21,727,273 = + ¥23,000,000 + ¥2,727,273

The NPV of immediate abandonment is ¥23,000,000. In this case, the timing option is worthless. The abandonment option has the most value if exercised immediately. Indeed, waiting one year foregoes the ¥23,000,000 intrinsic value, and hence has an opportunity cost of ¥2,727,273 relative to immediate abandonment.

e. V(abandon today) = ¥23,000,000 as in part b).

V|(P₁ = ¥50,000) < ¥0 ⇒ don’t abandon if price rises to ¥50,000

V|(P₁ = ¥20,000) = –[(((¥20,000/ton–¥40,000/ton)(500 tons)) / 0.10) / (1.10)]  ¥2,000,000

= ¥88,909,091 ⇒ abandon if price falls to ¥20,000

V(wait one year) = (½)(¥88,909,091) + (½)(¥0) = ¥44,454,545

This higher level of endogenous uncertainty increases the value of the timing option to ¥21,454,545. Wait one year before making an abandonment decision.