unit4_solutions_444

What is the key difference between the net present value approach and the risk-neutral valuation approach?

The net present value approach estimates cash flows in the real world and discounts them at a risk-adjusted rate, while the risk-neutral valuation approach estimates cash flows in a risk-neutral world and discounts them at the risk-free rate.

What is an advantage of the risk-neutral valuation approach for valuing real options?

It avoids the difficulty of determining an appropriate risk-adjusted discount rate for options.

What effect does increased uncertainty (higher standard deviation) have on the value of the expansion option?

It increases the value of the expansion option.

How does a more optimistic forecast affect the value of the expansion option?

It increases the value of the expansion option.

What is the impact of increasing the required investment on the value of the expansion option?

It reduces the value of the expansion option.

Why did the start-up company choose to rent furniture instead of buying it?

The option to sell or abandon the furniture provides flexibility if the start-up fails.

What assumption might be flawed when evaluating the economic life of a new plant?

The life of a project is not fixed; it can be abandoned or extended based on performance.

What is one major reason why quantitative valuation of real options is challenging?

Real options can be complex and not well-structured, making future events and decisions hard to outline.

True or False: Real-options analysis sometimes advises firms to invest in negative-NPV projects to secure growth opportunities.

True.

In the context of real options, what does an American call option represent?

The right to develop a project at a predetermined exercise price at a future date.

What scenario describes an American put option?

The right to abandon a project at a predetermined value, benefiting from exiting if it underperforms.

What is the significance of waiting before developing a land parcel?

It allows gathering more information about land prices and best use, creating a call option.

What is implied by a real estate developer using land as a parking lot instead of immediate construction?

It holds an American option to decide later whether to build a hotel or apartment building based on future profitability.

Why is it more beneficial to wait rather than exercise an option early?

In many cases, the option is worth more unexercised due to potential future increases in the underlying asset's value.

What does the Black-Scholes model help evaluate in finance?

The value of options by considering various market factors and the time to expiration.

What happens to the value of an option with increasing exercise costs?

The value may decrease due to higher costs associated with exercising the option.

How does the exercise price affect a call option's value over time?

An increasing exercise price reduces the call option's value as it becomes more expensive to exercise.

What is the purpose of creating a binomial tree for valuing options?

To model potential future outcomes and decide on the optimal time for exercising the option.

Why is a decision tree not sufficient for valuing options according to the text?

It fails to account for the changing discount rate as asset prices and time evolve.

What do real options allow firms to do regarding investment decisions?

Real options provide firms with the flexibility to adapt decisions based on new information or changes in the market.