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.