unit4_solutions_444

1. Net Present Value Approach vs. Risk-Neutral Valuation Approach

• Net Present Value (NPV) Approach:

  • Cash flows estimated in the real world.

  • Discounted at a risk-adjusted discount rate.

  • Suitable for traditional capital budgeting.

• Risk-Neutral Valuation Approach:

  • Cash flows estimated in a risk-neutral world.

  • Discounted at the risk-free interest rate.

  • More appropriate for valuing real options due to the difficulty in determining appropriate risk-adjusted rates.

• Advantages of Risk-Neutral Valuation:

  • Simplification of valuation by using the risk-free rate.

  • Focus on the potential upside of options rather than downside risk impact.

2. Valuation Changes for Expansion Option (Table 22.2 Review)

• Increased Uncertainty (Higher Standard Deviation):

  • Effect: Increases the value of the expansion option unless higher discount rates on cash flows apply.

• More Optimistic Forecast (Higher Expected Value):

  • Effect: Increases the value of the expansion option due to higher expected cash flows.

• Increase in the Required Investment:

  • Effect: Reduces the value of the expansion option as expected cash flows decrease.

3. Start-Up Furniture Investment Decision

• Decision: Renting vs. Buying

• Reason for Renting:

  • Flexibility in operations; can abandon furniture if start-up fails.

  • Abandonment value of used furniture is low.

4. Economic Life Assumption in Plant Evaluation

• Issue: Economic life of 10 years may not be fixed.

• More Complete Analysis:

  • Consider options to abandon or extend plant life.

  • Assess performance implications on the abandonment option.

5. Advantages of Waiting on Land Development

• Advantage of Waiting:

  • Opportunity to learn more about market values and land use (call option).

• Reason to Develop Immediately:

  • Immediate capture of rental income to offset property costs.

6. Existence of Gas Turbines

• Efficiency: Gas turbines are less efficient.

• Reason for Existence:

  • Flexibility in production, can ramp up quickly based on market demand.

• Valuable Option: Decision to run or not run turbines based on economic conditions.

7. Challenges in Quantitative Valuation of Real Options

• Complexity: Many problems are not well-structured.

• Roadmaps for Future Events: Difficult to outline decisions and events.

• Competitive Interactions: Increase the complexity of assessment.

8. True or False Questions

• a. True: Negative-NPV may secure growth options.

• b. True: Greater uncertainty makes options valuable, postponing cash flows.

• c. True: Binomial trees can evaluate options accurately.

• d. True: Risk-neutral methods allow for valuation as if traded.

• e. True: Investing in a large plant can be better than multiple smaller projects.

9. Creating Real Options as Financial Managers

• Ways to Create Real Options:

  • Plan initial projects to allow later expansion.

  • Invest in modular facilities instead of large scale projects.

  • Utilize standardized equipment with good salvage values.

  • Delay investments to gather information (timing option).

10. Drilling Rights Language of Options

• Situation: Negative-NPV development with a break-even price of C$90.

• Option: A five-year American call option on oil with an exercise price rising at 5% per year.

11. Restaurant Cash Flow Described as Options

• Situation: Annual cash flow of $700,000.

• Option: American put option to abandon the restaurant with an exercise price of $5 million.

12. Variation on Restaurant Cash Flow Options

• Fixed Costs: Known costs resulting in net cash flow of $700,000.

• Exercise Price Calculation: $5 million real estate value plus avoided future fixed costs, totaling $8 million.

13. Paper Mill Operational Flexibility as Options

• Situation: Ability to shut down and restart in response to demand changes.

• Complex Option: American put and call options allowing for temporary abandonment and restarting.

14. Real Estate Development Choices as Options

• Situation: Developer uses land as a parking lot instead of immediate construction.

• Option: In-the-money American option to choose either a hotel or apartment building later.

15. Air France Boeing Purchase Options

• Situation: Air France negotiates a purchase option with confirmation needed by 2014.

• Option: Call option fixing delivery date and pricing.

16. Mark II Project Investment Valuation Changes

• Investment Required Change: From $900 million to $800 million increases option value.

• Present Value Change: From $467 million to $500 million increases option value.

• Standard Deviation Change: From 35% to 20% decreases option value.

17. Call Option on Real Estate Value

• Situation: One-year call option on land with exercise price of $2 million.

• Value Calculation: Using standard model methods, it’s worth approximately $71,100.

18. European Call Option on Warehouse

• Situation: Warehouse generates rents affecting land value.

• Value Calculation: Approximately $28,600 after rent payouts considered.

19. Option to Purchase Overland Railroad Assets

• Current PV: Estimated at $2.7 billion with cash flows included.

• Comparison of Options: Should model ability to exercise now versus future.

20. Responses to Comments on Valuing Flexibility

• a: One discount rate cannot apply without accounting for changes in risk.

• b: Options on risky assets are often more valuable due to their potential upside.

• c: DCF valuation remains essential for determining the underlying asset value.

21. Josh Kidding’s Valuation Approach

• Assessment: Will not yield the right answer due to failure to adjust discount rates based on changing risks.