Fina 3001

Q: What is a real option in capital budgeting?
A: A real option is the right, but not the obligation, to undertake certain business decisions, such as deferring, expanding, contracting, or abandoning a project.
Q: Which two main frameworks are used to value real options?
A: The binomial framework and the Black–Scholes framework.
Q: What are risk-neutral probabilities?
A: Probabilities adjusted for risk, used in option valuation to discount expected cash flows at the risk-free rate.
Q: Why might managers refrain from using real-option techniques?
A: Due to opaque framing, where the process and outcomes are not intuitively clear to them.
Q: How does excessive optimism affect investment policies using real options?
A: It leads managers to overestimate future cash flows, potentially resulting in overinvestment.
Q: How does overconfidence impact managers' use of real options?
A: Overconfident managers underestimate risks, leading them to undertake risky projects.
Q: What is the option to defer in real-option analysis?
A: The flexibility to delay investment until more information is available.
Q: What is the abandonment option?
A: The ability to cease a project to cut losses if it becomes unprofitable.
Q: Why do some firms prefer decision tree analysis over real-option techniques?
A: Decision trees are simpler and do not require complex risk-neutral probability calculations.
Q: What is asset substitution in capital structure?
A: When equity holders prefer riskier projects because they benefit from upside gains while debt holders bear downside risk.
Q: How does real-option analysis mitigate debt overhang?
A: By quantifying the value of waiting and strategic investments, encouraging managers to pursue positive NPV projects.
Q: What behavioral factor makes real-option techniques underutilized?
A: The complexity of risk-neutral probabilities, which are perceived as unintuitive.
Q: How does the put option concept relate to equity holders in a leveraged firm?
A: Equity holders can "put" the firm to debt holders by defaulting when firm value falls below debt obligations.
Q: What psychological bias might prevent managers from abandoning failing projects?
A: The sunk cost fallacy.
Q: How does optimism influence the timing of exercising real options?
A: Optimistic managers may exercise options too early, underestimating the value of waiting.
Q: What is the difference between transparent and opaque framing?
A: Transparent framing makes decision consequences clear; opaque framing makes them difficult to discern.
Q: Why did Sun Microsystems avoid adopting real-option techniques?
A: They believed real options were used to justify overvalued tech stocks during the dot-com bubble.
Q: What industries are more likely to use real-option techniques?
A: Technology and pharmaceuticals, due to high uncertainty in innovation.
Q: What is the main disadvantage of using a constant discount rate in decision analysis?
A: It fails to adjust for changing risk over a project's life.
Q: How can debt covenants address agency conflicts?
A: By restricting risky investments that would harm debt holders.

Section 2: Behavioral Aspects of Investment Valuation

Q: What is the Efficient Market Hypothesis (EMH)?
A: The theory that asset prices fully reflect all available information.
Q: Name one anomaly that challenges the EMH.
A: Momentum effect.
Q: What is extrapolation bias?
A: The tendency to assume recent trends will continue into the future.
Q: How does overconfidence affect active investing?
A: It leads investors to believe they can consistently outperform the market.
Q: What is the Baker-Wurgler Sentiment Index used for?
A: Measuring investor sentiment and its impact on market behavior.
Q: What psychological heuristic influences investors to prefer well-known stocks?
A: The affect heuristic.
Q: What causes the closed-end fund discount anomaly?
A: Investor sentiment and mispricing due to illiquidity.
Q: How does representativeness bias affect investment decisions?
A: Investors judge the likelihood of events based on similarity to stereotypes rather than actual probabilities.
Q: What is post-earnings-announcement drift?
A: The tendency for stock prices to drift in the direction of an earnings surprise after the announcement.
Q: What role do "limits to arbitrage" play in market inefficiencies?
A: They prevent rational investors from correcting mispricings caused by irrational behavior.
Q: What is a key criticism of CAPM highlighted by behavioral finance?
A: CAPM assumes rational behavior, ignoring psychological biases.
Q: How do behavioral biases impact fund performance?
A: They lead to systematic errors in fund manager decisions, affecting returns.
Q: What factor models try to address anomalies unexplained by CAPM?
A: The Fama-French three-factor model.
Q: Why do investors chase past performance in mutual funds?
A: Due to representativeness bias, believing past returns predict future success.
Q: What behavioral explanation exists for IPO underpricing?
A: Over-optimism among investors about future growth prospects.
Q: How can behavioral finance explain stock market bubbles?
A: Herding behavior and overconfidence drive asset prices beyond fundamental values.
Q: What is the disposition effect?
A: Investors' tendency to sell winning stocks too early and hold losing stocks too long.
Q: How does herd behavior affect market volatility?
A: It amplifies price swings as investors mimic each other's actions.
Q: What is the main difference between active and passive investing?
A: Active investing involves selecting stocks to outperform the market; passive investing tracks market indices.
Q: Why do behavioral factors suggest some active strategies may outperform?
A: Active managers may exploit inefficiencies created by investor biases.

Section 3: Application & Critical Thinking

Q: How can real-option techniques address behavioral biases in investment decisions?
A: By providing structured frameworks that counteract impulsive decisions driven by overconfidence or optimism.
Q: In what way does excessive optimism benefit capital structure decisions?
A: It may lead managers to take on optimal leverage by underestimating bankruptcy risks.
Q: What would happen if debt holders assume managers are overconfident?
A: They may price debt lower due to reduced concerns about agency conflicts.
Q: How can real-option analysis improve technology investment decisions?
A: By valuing the flexibility to expand projects only if the technology proves successful.
Q: How does overconfidence influence the valuation of a firm’s equity?
A: Overconfident managers may overvalue equity by underestimating associated risks.
Q: Why might behavioral biases cause firms to underutilize real options?
A: Because complex mathematical models feel counterintuitive compared to heuristics.
Q: How does waiting to invest add value in real-option analysis?
A: It allows managers to avoid losses by observing future market conditions before committing resources.
Q: Describe how risk-neutral valuation helps in pricing real options.
A: It estimates expected values of future cash flows, adjusted for risk, and discounts them at the risk-free rate.
Q: What behavioral factor might lead managers to overinvest in projects with embedded growth options?
A: Overconfidence in projected future growth.
Q: How does real-option analysis help mitigate the impact of the sunk cost fallacy?
A: By emphasizing the value of future options rather than past investments.