Name: Class: Date:
CHAPTER 24 - DECISION TREES, REAL OPTIONS AND OTHER CAPITAL BUDGETING
TECHNIQUES
1. Real options are options to buy real assets, such as stocks, rather than interest-bearing assets, such as bonds.
a. True
b. False
ANSWER: False
2. Real options are most valuable when the underlying source of risk is very low.
a. True
b. False
ANSWER: False
3. Real options affect the size, but not the risk, of a project’s expected cash flows.
a. True
b. False
ANSWER: False
4. Commodore Corporation is deciding whether to invest in a project today or to postpone the decision until next year.
The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be
negative. No competitors are likely to invest in a similar project if Commodore decides to wait. Which of the following
issues should Commodore consider most seriously when making this investment decision?
a. The more uncertainty about the future cash flows, the more logical it is for Commodore to go ahead with this
project today.
b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it
chooses to wait a year.
c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in
that NPV.
d. Waiting would probably reduce the project’s risk.
ANSWER: d
5. Which one of the following is an example of a flexibility option?
a. A company has an option to invest in a project today or to wait a year.
b. A company has an option to close down an operation if it turns out to be unprofitable.
c. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs
at a later date if conditions change.
d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at
a later date.
ANSWER: c
6. Which of the following is NOT a real option?
a. the option to expand production if the product is successful
b. the option to buy shares of stock if its price goes up
c. the option to expand into a new geographic region
d. the option to switch the type of fuel used in an industrial
furnace
ANSWER: b
, Name: Class: Date:
CHAPTER 24 - DECISION TREES, REAL OPTIONS AND OTHER CAPITAL BUDGETING
TECHNIQUES
7. Which circumstance will NOT increase the value of a real option?
a. lengthening the time in which a real option must be exercised
b. an increase in the volatility of the underlying source of risk
c. an increase in the risk-free rate
d. an increase in the cost of obtaining the real option
ANSWER: d
8. Which of the following best describes real options?
a. Real options change the size, but not the risk, of projects’ expected cash flows.
b. Real options change the risk, but not the size, of projects’ expected cash flows.
c. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash
flows.
d. Very few projects actually have real options.
ANSWER: c
9. Lighthouse Corporation uses the NPV method for selecting projects, and it does a reasonably good job of estimating
projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the
following statements is most likely to describe its situation?
a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options
are taken into account.
b. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth
options.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large,
but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is
unclear what impact not considering real options has on the overall capital budget.
d. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small,
but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is
unclear what impact not considering real options has on the overall capital budget.
ANSWER: a
10. Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties and then selling the successful
ones to major oil refining companies. TWI is now considering a new potential field, and its geologists have developed the
following data, in thousands of dollars.
CHAPTER 24 - DECISION TREES, REAL OPTIONS AND OTHER CAPITAL BUDGETING
TECHNIQUES
1. Real options are options to buy real assets, such as stocks, rather than interest-bearing assets, such as bonds.
a. True
b. False
ANSWER: False
2. Real options are most valuable when the underlying source of risk is very low.
a. True
b. False
ANSWER: False
3. Real options affect the size, but not the risk, of a project’s expected cash flows.
a. True
b. False
ANSWER: False
4. Commodore Corporation is deciding whether to invest in a project today or to postpone the decision until next year.
The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be
negative. No competitors are likely to invest in a similar project if Commodore decides to wait. Which of the following
issues should Commodore consider most seriously when making this investment decision?
a. The more uncertainty about the future cash flows, the more logical it is for Commodore to go ahead with this
project today.
b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it
chooses to wait a year.
c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in
that NPV.
d. Waiting would probably reduce the project’s risk.
ANSWER: d
5. Which one of the following is an example of a flexibility option?
a. A company has an option to invest in a project today or to wait a year.
b. A company has an option to close down an operation if it turns out to be unprofitable.
c. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs
at a later date if conditions change.
d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at
a later date.
ANSWER: c
6. Which of the following is NOT a real option?
a. the option to expand production if the product is successful
b. the option to buy shares of stock if its price goes up
c. the option to expand into a new geographic region
d. the option to switch the type of fuel used in an industrial
furnace
ANSWER: b
, Name: Class: Date:
CHAPTER 24 - DECISION TREES, REAL OPTIONS AND OTHER CAPITAL BUDGETING
TECHNIQUES
7. Which circumstance will NOT increase the value of a real option?
a. lengthening the time in which a real option must be exercised
b. an increase in the volatility of the underlying source of risk
c. an increase in the risk-free rate
d. an increase in the cost of obtaining the real option
ANSWER: d
8. Which of the following best describes real options?
a. Real options change the size, but not the risk, of projects’ expected cash flows.
b. Real options change the risk, but not the size, of projects’ expected cash flows.
c. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash
flows.
d. Very few projects actually have real options.
ANSWER: c
9. Lighthouse Corporation uses the NPV method for selecting projects, and it does a reasonably good job of estimating
projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the
following statements is most likely to describe its situation?
a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options
are taken into account.
b. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth
options.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large,
but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is
unclear what impact not considering real options has on the overall capital budget.
d. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small,
but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is
unclear what impact not considering real options has on the overall capital budget.
ANSWER: a
10. Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties and then selling the successful
ones to major oil refining companies. TWI is now considering a new potential field, and its geologists have developed the
following data, in thousands of dollars.
