EFM 13
Chapter 13
Real Options and Other Topics in Capital Budgeting
Learning Objectives
After reading this chapter, the student should be able to:
Explain why conventional NPV analysis may not capture a project’s impact on the firm’s opportunities.
Identify five different types of real options.
Explain what an abandonment/shutdown option is, give an example of a project that includes this type of option, and explain what an option value is.
Explain what a decision tree is and provide an example of one.
Explain what an investment timing option is, and give an example of a project that includes one.
Explain what a growth option is, and give an example of a project that includes one.
Explain what a flexibility option is, and give an example of a project that includes one.
Use the replacement chain and equivalent annual annuity methods to compare projects with unequal lives, and explain when you might use one method over the other.
List the steps a firm goes through when establishing its optimal capital budget in practice.
Lecture Suggestions
This chapter covers some important but relatively technical topics. Note too that this chapter is more modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip sections or even the entire chapter.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 13, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 58 DAYS (50-MINUTE PERIODS)
Answers to End-of-Chapter Questions
13-1 a. An abandonment option is the option to abandoning a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk, because in
Real Options and Other Topics in Capital Budgeting
Learning Objectives
After reading this chapter, the student should be able to:
Explain why conventional NPV analysis may not capture a project’s impact on the firm’s opportunities.
Identify five different types of real options.
Explain what an abandonment/shutdown option is, give an example of a project that includes this type of option, and explain what an option value is.
Explain what a decision tree is and provide an example of one.
Explain what an investment timing option is, and give an example of a project that includes one.
Explain what a growth option is, and give an example of a project that includes one.
Explain what a flexibility option is, and give an example of a project that includes one.
Use the replacement chain and equivalent annual annuity methods to compare projects with unequal lives, and explain when you might use one method over the other.
List the steps a firm goes through when establishing its optimal capital budget in practice.
Lecture Suggestions
This chapter covers some important but relatively technical topics. Note too that this chapter is more modular than most, i.e., the major sections are discrete, hence they can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip sections or even the entire chapter.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 13, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 58 DAYS (50-MINUTE PERIODS)
Answers to End-of-Chapter Questions
13-1 a. An abandonment option is the option to abandoning a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk, because in