Real Option

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Practice Questions-“Real Options”

Some questions may require you to use financial calculator or Excel. (In the final exam, for students without financial calculator, writing down the formula will be enough. However, those formulas must be correct to get full credit. Therefore, it is a good practice to check whether you are correct by using Excel for these practice questions)

1. How are real options different from financial options?

2. Consider the following project data:

(1)A $500 feasibility study will be conducted at t = 0. (2)If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not. (3)If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor. (4)If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.

If the appropriate cost of capital is 10 percent, what is the project's expected NPV?

Answer : $35

To find the NPV of the first outcome:
NPV = -$500 - 1000/1.1 - 1000/(1.1)^2 + 16000/(1.1)^3 = $2,347.48 The other NPVs can be found similarly.
E(NPV) = 0.24($2,347) + 0.24($94) + 0.32(-$1,409) + 0.20(-$500) = $35. (The following information applies to the next two problems.)

3. Diplomat.com is considering a project that has an up-front cost of $3 million and produces an expected cash flow of $500,000 at the end of each of the next five years. The project’s cost of capital is 10 percent.

Based on this information what is the project’s net present value?

Answer : -$1,104,607

4. If Diplomat goes ahead with this...
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