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Exam 12: Risk Topics and Real Options in Capital Budgeting

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Question 31

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In theory, the certainty equivalents imply zero risk.

A) True
B) False

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Question 32

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If a low cash flow this year makes a low cash flow next year more likely to occur, this means the project cash flows tend to be ____.

A) less predictable
B) independent of each other
C) more volatile
D) correlated

E) A) and B)
F) B) and C)

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Question 33

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Richmond Graphics is a small company contemplating a project with a $5M initial investment. A traditional capital budgeting analysis shows the project to have an NPV of $3.3M. However, a simple decision tree analysis reveals that the project has a 90% probability of an NPV of $4.0M and a 10 % chance of a ($3.0M) loss NPV. Management should probably:

Explain the certainty equivalent approach.

Komarek Forests is considering a new software package that may improve productivity over the next two years. There is a sixty percent chance that the project will be a success in Year 1, earning $2 million and a forty percent change that the venture will fail during the first year resulting in a $1 million loss due to worse asset management than under the current system. The original system would be reinstalled, resulting in no additional losses during the second year. If the project is a success in the first year, there is an eighty percent chance that it will earn $3 million in the second year. There is a twenty percent chance that the software will be ineffective in Year 2, despite success in Year 1, in which case there would be a loss of $500,000. Assuming a nine percent required rate of return on these, and a total cost of the software system of $500,000, should Komarek install the new system?

Consideration of risk is essential to the capital budgeting process. Which of the following statements is true?

Portfolio theory makes it possible to incorporate Risk into capital budgeting through risk adjusted returns. However, portfolio theory omits an important element of risk that is relevant in capital budgeting. That missing element is:

Which of the following is not a drawback of the simulation approach?

An abandonment option will have an upfront cost of $1.0 million. There is a 40% chance that the abandonment option would be used, in which case cash outflows of $800,000 in Year 4, $1,400,000 in Year 5 and $1,200,000 in Year 6 will be avoided. If the discount rate is 7.0%, should the abandonment option be exercised?

Muller, Inc., manufacturer of cardboard boxes, is considering taking on a new line of quality stationery, a related but very different field than cardboard boxes. Management has prepared a, six-year forecast for the project planning to reevaluate the venture after that time. The forecast anticipates that the project will cost $2 million to start after which it will generate $500,000 in each of the next six years. To be conservative a $200,000 shut down cost at the end of the sixth year has also be forecast. Muller's beta is 1.2, but Nugent Paper, a rival stationery manufacturer that does nothing else, is known to have a beta of 1.6. The return on an average stock is 9%, and the risk free rate is 5%. Muller's cost of capital is 8%. a. What is the NPV of the stationery project if Muller uses the traditional cost of capital method for calculating NPV? b. Assume that Nugent Paper is a pure play company for Muller's project. What is the NPV of the project using Nugent Paper and the pure play method? c. What should Muller do? Why? $(000)

Why should a risk averse manager select one project over another when both projects generate the same NPV?

Decision tree analysis shows a project to have several possible outcomes the best of which has an NPV of $10M calculated over a five year life. This best case path has an overall probability of occurring of 25%. A real option is available at an initial cost of $750,000 which will add a single $5M cash inflow to this best case path at its end. The option doesn't have a significant effect on the project's risk. The company's cost of capital is 11%. What is the option's value (to the nearest $1,000) ?

The value of a real option is at least the increase in the project's estimated NPV arising from the option's inclusion.

What is Monte Carlo simulation? How is it used in the capital budgeting?

Scenario/sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the ____ is to changes in a particular variable.

Decision tree analysis let us approximate the NPV distribution if we can estimate the probability of certain events within the project.

When incorporating risk into capital budgeting through the interest rate used in NPV or IRR calculations, the rates used are called:

The probability of a path is also called the conditional probability of the individual branches along it.

Suppose a firm builds a plant with more space than the firm currently needs. What type of real option best describes the firm's behavior?

An automatic bias against high-risk projects is created by: