ease write down your choice in the blank before the question. Two points each an
ID: 2809228 • Letter: E
Question
ease write down your choice in the blank before the question. Two points each and 10 points in total. Which of the following statements regarding capital budgeting is NOT CORRECT? a. The conventional NPV method is good enough for capital budgeting because it fully recognizes the value created by a project. The conventional NPV method is not good enough because it fails to account for the value of real options. Real options would create additional values for an investment project and hence may turn a negative-NPV project into an acceptable one. Failing to consider real options would cause underinvestment. b. c. d. 2. A manager do NOT want to consider deferring a project if a. Investing immediately would create a large first-mover advantage in the market b. More information can be collected to better estimate the cash flows. c. The cost of capital is expected to be lower in the future. d. The market demand is very low currently but may grow in the future. 3. In our example of replication option, what are the appropriate discount rates for cash flows? a. The WACC for all cash flows b. The risk-free rate for all cash flows. c. The risk-free rate for the initial investment of the replication project and the WACC for all others. The WACC for the initial investment of the replication project and the risk-free rate for all others. d. 4. In our example of abandonment option, the option is not exercised if the market demand turns out mediocre, because a. The project is a positive-NPV project in that scenario. b. The project enhances the shareholder wealth in that scenario. c. The project is a negative-NPV project, but terminating it would cut the loss. d. The project is a negative-NPV project, but terminating it would make it an even wor project. 5, Which of the following statements regarding real options is NOT correct?Explanation / Answer
1.
b
The conventional NPV method is not good enough because it fails to account for the value of the real options.
This is not true because a real option is a right but not an obligation to undertake a certain activity. Hence there is the option to use a plain vanilla NPV method or NPV with real options.
d
Failing to consider real options would cause underinvestment.
This is not true because a real option is a decision making tool which is used to enhance, defer, expand or abandon a project and has no direct bearing on the amount invested.
2.
a
Investing immediately would create a large first-mover advantage in the market.
First mover advantages are extremely crucial as they give a company a head start in the market enabling them to garner a significant chunk of the market share. Hence such opportunities are never delayed.
c
The cost of capital is expected to be lower in the future.
If the NPV of a project is positive and significant, then waiting for the cost of capital to get lower may improve the profitability of the project but might lead to losing out on major opportunities like first mover advantage, market penetration, skimming opportunities,etc. Thus it would be prudent to move on with the project than to wait for the cost of capital to get lower.
3.
a
The WACC for all cash flows
b
The risk free rate for all cash flows.
Discounting is always done using a uniform standard rate.
4.
a
The project is a positive NPV project in that scenario
b
The project enhances the shareholder wealth in that scenario.
A project may only be abandoned if it helps in cutting losses. A negative NPV project is always rejected and hence statements c and d are incorrect.
5.
c
Real options affect the size as well as the risk of the expected cash flows
d
Real options are more valuable when the underlying source of risk is low.
A real option is a decision making tool which is used to enhance, defer, expand or abandon a project and has no direct bearing on the amount invested
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