Real Option free essay sample

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. We will write a custom essay sample on Real Option or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Based on this information what is the project’s net present value? Answer : -$1,104,607 4. If Diplomat goes ahead with this project today, the project will create additional opportunities five years from now (t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information that is available today, the company estimates that there is a 35 percent chance that its technology will be successful, in which case the future investment opportunities will have a net present value of $6 million at t = 5. There is a 65 percent chance that its technology will not succeed, in which case the future investment opportunities will have a net present value of -$6 million at t = 5. Diplomat. com does not have to decide today whether it wants to pursue these additional opportunities. Instead, it can wait until after it finds out if its technology is successful. However, Diplomat. com cannot pursue these additional opportunities in the future unless it makes the initial investment today. What is the estimated net present value of the project, after taking into account the future opportunities? Enter the following data inputs in the financial calculator: N = 5; I = 10; PMT = 0; FV = 2,100,000; and then solve for PV = $1,303,935. Step 3: Find the NPV of the entire project considering its future opportunities: -$1,104,607 + $1,303,935 = $199,328. (The following information applies to the next two problems. ) 5. Oklahoma Instruments (OI) is considering a project that has an up-front cost of $250,000. The project’s subsequent cash flows critically depend on whether its products become the industry standard. There is a 50 percent chance that the products will become the industry standard, in which case the project’s expected cash flows will be $110,000 at the end of each of the next five years. There is a 50 percent chance that the products will not become the industry standard, in which case the project’s expected cash flows will be $25,000 at the end of each of the next five years. Assume that the cost of capital is 12 percent. Based on this information, what is the project’s expected net present value? Answer : -$ 6,678 6. Now assume that one year from now OI will know if its products will have become the industry standard. Also assume that after receiving the cash flows at t = 1, the company has the option to abandon the project. If it abandons the project it will receive an additional $100,000 at t = 1, but will no longer receive any cash flows after t = 1. Assume that the abandonment option does not affect the cost of capital. What is the NPV of the project with this abandonment option? Answer : $4,066 or 4,067 The time line of cash flows are as follows. t=0 : -250,000 With probability 0. 5, t=1 to t=5 : 110,000 And with probability 0. 5, t=1 : 125,000