Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
12th Edition
ISBN: 9781259144387
Author: Richard A Brealey, Stewart C Myers, Franklin Allen
Publisher: McGraw-Hill Education
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Textbook Question
Chapter 22, Problem 18PS
Real options Respond to the following comments.
- a. “You don’t need option pricing theories to value flexibility. Just use a decision tree. Discount the cash f lows in the tree at the company cost of capital.”
- b. “These option pricing methods are just plain nutty. They say that real options on risky assets are worth more than options on safe assets.”
- c. “Real-options methods eliminate the need for DCF valuation of investment projects.”
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Students have asked these similar questions
Which of the following statements is FALSE?
A.
You invest today only when the NPV of investing today exceeds the value of the option of waiting, which from option pricing theory we know to be always positive.
B.
When you do not have the option to wait, it is optimal to invest in any
positive−NPV
project.
C.
One way to see why you sometimes choose not to invest in a
positive−NPV
project is to think about the decision of when to invest as a choice between two mutually exclusive projects: (1) invest today or (2) wait.
D.
When you have the option of deciding when to invest, it is usually optimal to invest only when the NPV is positive but close to zero.
Financial advisors generally recommend that their clients allocate more to higher risk–return asset classes (like equities) if their investment horizons are long.
Is this advice consistent with the basic M-V model?
Does adding a shortfall constraint to the M-V model make a difference? If so, how? If not, why not?
Assuming investment opportunities change over time, what type of asset return behavior would justify this advice within the M-V framework?
d. Consider the following statement "If an analyst decides to use real options
methodology to value a project, estimating a standard Discounted Cash Flow
model is useless". Do you agree with this statement? Explain your answer.
Chapter 22 Solutions
Principles of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
Ch. 22 - Expansion options Look again at the valuation in...Ch. 22 - Prob. 2PSCh. 22 - Prob. 3PSCh. 22 - Prob. 4PSCh. 22 - Prob. 5PSCh. 22 - Prob. 6PSCh. 22 - Real options True or false? a. Real-options...Ch. 22 - Prob. 8PSCh. 22 - Prob. 9PSCh. 22 - Expansion options Look again at Table 22.2. How...
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- Real options analysis is an investment analysis tool that looks at an investment or activity as a series of sequential steps, and for each step, the investors have the option of: 1) investing additional funds to grow or accelerate, 2) delaying, shrinking the scale of, or abandoning an activity. However, analyzing and making decisions on these options is often easier said than done. Which of the following illustrates the potential pitfalls of real option analysis? The managers involved with the analysis lose their ability to objectively assess the options due to an inflated sense of their ability to reduce risks inherent in the decision-making process. Due to a lack of subjectivity when formally modeling a real option, managers may have an incentive to choose variance values that diminish the likelihood of project approval. A prevailing tendency on the part of managers to operate in a highly conservative manner thereby resulting in the investment approval criteria not being met. A…arrow_forwardChoose option a,b,c,d,e for the following: Question 6 - A higher financial risk: a. Arises when the debt – equity ratio is reduced. b. Can avert financial distress. c. Will cause the shareholders to expect lesser return. d. Indicates an inefficient use of fixed cost assets. e. Indicates an inefficient use of fixed cost funds.arrow_forward(1) Why is the risk-free return independent of the state of the economy? Do T-bills promise a completely risk-free return? (2) Why are High Tech’s returns expected to move with the economy whereas Collections’ are expected to move counter to the economy? Calculate the expected rate of return on each alternative and fill in the row for in the table. You should recognize that basing a decision solely on expected returns is appropriate only for risk-neutral individuals. Because the beneficiaries of the trust, like virtually everyone, are risk averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns. (1) Calculate this value for each alternative, and fill in the row for σ in the table. (2) What type of risk does the standard deviation measure? (3) Draw a graph that shows roughly the shape of the probability distributions for High Tech, U.S. Rubber, and T-bills. Suppose you suddenly remembered that…arrow_forward
- In our study of Real Options, we learned about the many benifits of Real Options. Of the below, which is FALSE? O A. Given the option to delay, an investment that currently has a negative NPV can have a positive value. O B. As the level of uncertainty increases, the benefit of waiting is diminished. OC. In a real option analysis, the dividends correspond to any value from the investment that we give up by waiting. O D. By delaying an investment, we can base our decision on new information.arrow_forwardA risk-loving person (select all that applies) Group of answer choices a) will never make an investment with a risk-free payoff. b) has a convex utility function of income. c) has a concave utility function of income. d) will always choose the alternative with the largest risk. e) has increasing marginal utility of income.arrow_forwardWhich of the following is NOT true? You might be better off using elimination approach for this question if your other courses (Financial Management, Investment/Portfolio Management) did not familiarize yourself with the concept of risk-neutrality. In risk-neutral valuation the risk-free rate is used to discount expected cash flows In risk-neutral valuation the expected return on all investment assets is set equal to the risk-free rate O Derivatives can be valued based on the assumption that investors are risk neutral O Risk-neutral valuation provides prices that are only correct in a world where investors are risk-neutral None of these (i.e. all are TRUE)arrow_forward
- True or Falsearrow_forwardLet C be the price of a call option to purchase a security whose present price is S. Explain why C is less than or equal to S. I'm just thinking it wouldn't make financial sense to pay more for the call option than the present price of the security. I'm not sure if there is more of an explanation that is needed. I was also wondering is there any time when it would be favorable to pay more for the call option than the present price of the security?arrow_forwardConsider the following statement: “In contexts of increased uncertainty, the usefulness of real options when valuing an investment opportunity increases”. Do you agree with this statement? Explain your answer.arrow_forward
- Thanks you for the previous answer. I will just research about the terms. Can you also please help me answer this 2 questions. No need for explanation. Thank youarrow_forwardIf we use future value rather than present value to decide whether to make an investment, A) we will make a bad decision, since the future value will always be higher if the discount rate is positive. B) we will make a bad decision, since the future value will always be lower if the discount rate is positive. C) we will make the same decision using either future value or present value. D) There is not enough information given to answer the question.arrow_forwardConsider the following two statements concerning risk analysis: 1. Sensitivity analysis provides clear decision rules concerning acceptance or rejection of an investment project. 2. The risk-adjusted discount rate adds a risk premium to the expected rate of inflation to deriv a discount rate for investment projects. Which one of the following combinations (true/false) relating to the above statements is correct? O a. Statement 1 True Statement 2 False O b. none of the answer provided are correct Statement 1 True Statement 2 True Statement 2 False c. d. Statement 1 False O e. Statement 1 False Statement 2 Truearrow_forward
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