1. What is real option analysis?

ANSWER: [SHOW S12-41 HERE.] REAL OPTIONS EXIST WHEN MANAGERS CAN INFLUENCE THE SIZE AND RISKINESS OF A PROJECT’S CASH FLOWS BY TAKING DIFFERENT ACTIONS DURING OR AT THE END OF A PROJECT’S LIFE.

REAL OPTION ANALYSIS IN THE TYPICAL NPV CAPITAL BUDGETING ANALYSIS INCLUDES AN ANALYSIS FOR OPPORTUNITIES FOR MANAGERS TO RESPOND TO CHANGING CIRCUMSTANCES BECAUSE MANAGEMENT’S ACTIONS CAN INFLUENCE A PROJECT’S OUTCOME.

M. 2. WHAT ARE SOME EXAMPLES OF PROJECTS WITH EMBEDDED REAL OPTIONS?

ANSWER: [SHOW S12-42 HERE.] A PROJECT MAY CONTAIN ONE OR MORE DIFFERENT TYPES OF EMBEDDED REAL OPTIONS. EXAMPLES INCLUDE ABANDONMENT/SHUTDOWN OPTIONS, INVESTMENT TIMING OPTIONS, GROWTH/EXPANSION OPTIONS, AND FLEXIBILITY OPTIONS.

Solution to appendix 12a problem

12A-1 Year MACRS S-L Dep Dep T(Dep)

0 $ 0

1 $10,000,000 $10,000,000 $ 0 0

2 18,000,000 10,000,000 8,000,000 2,800,000

3 14,000,000 10,000,000 4,000,000 1,400,000

4 12,000,000 10,000,000 2,000,000 700,000

5 9,000,000 10,000,000 (1,000,000) (350,000)

6 7,000,000 10,000,000 (3,000,000) (1,050,000)

7 7,000,000 10,000,000 (3,000,000) (1,050,000)

8 7,000,000 10,000,000 (3,000,000) (1,050,000)

9 7,000,000 10,000,000 (3,000,000) (1,050,000)

10 6,000,000 10,000,000 (4,000,000) (1,400,000)

11 3,000,000 0 3,000,000 1,050,000

PV @ 9% = $1,310,841

Therefore, the value of the firm would be increased by $1,310,841, each year, if it elected to use standard MACRS depreciation rates.

Harcourt, Inc. Learning Objectives: 12 - 1