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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Answer 1

Textbook Question

Chapter 22, Problem 1PS

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.”

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

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4. Introduction to real options Consider the following statement about real options: Decision tree analysis is more commonly used in valuing securities than real assets. True or False: The preceding statement is correct. True False Which type of real option allows a project to be expanded if demand turns out to be greater than expected? Flexibility option Abandonment option Expansion option Timing option Consider the following example: Smoltz Motors has plants around the country that specialize in specific models of cars. Smoltz has determined that lower demand has led the firm’s inventory of SUVs to be too high. Smoltz wants to stop production for its SUVs and focus on its sedans. This example describes a real option to (expand/ abandon) . Please do not answer in excel, use math formulas Thank you!

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?

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…

Answer 2

Textbook Question

Chapter 22, Problem 1PS

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.”

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

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Answer 3

Textbook Question

Chapter 22, Problem 1PS

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.”

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

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Answer 4

Textbook Question

Chapter 22, Problem 1PS

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.”

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

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Answer 5

Textbook Question

Answer 6

Textbook Question

Answer 7

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

Answer 8

a.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

Answer 9

a.

Expert Solution

Answer 10

a.

Expert Solution

Answer 11

Expert Solution

Answer 12

Summary Introduction

To discuss: To respond to the statement on whether to use a decision tree rather using option theories.

Answer 13

Explanation of Solution

The possible response to the given statement is as follows:

Discount rates cannot be used for any of the option payoffs, because the risk of the option varies as the asset value changes time to time.

Answer 14

b.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

Answer 15

b.

Expert Solution

Answer 16

b.

Expert Solution

Answer 17

Expert Solution

Answer 18

Summary Introduction

To discuss: To respond to the statement on whether option pricing methods are plain nutty.

Answer 19

Explanation of Solution

The possible response to the given statement is as follows:

The risky asset might be worth less as an outcome of its riskiness, yet the option on the risky asset is progressively significant on the grounds that the option proprietor can underwrite from upward moves while not losing because of downward moves.

Answer 20

c.

Expert Solution

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

Answer 21

c.

Expert Solution

Answer 22

c.

Expert Solution

Answer 23

Expert Solution

Answer 24

Summary Introduction

To discuss: To respond to the statement on whether real options methods eliminate the discount cash flow valuation.

Answer 25

Explanation of Solution

The possible response to the given statement is as follows:

The worth of an option relies upon the value of the underlying asset. The discounted cash flow valuation of investment projects is vital so as to decide the worth of the underlying asset.

Answer 26

Ch. 22 - Real options Respond to the following comments. a....Ch. 22 - Prob. 2PS Ch. 22 - Real options True or false? a. Real-options...Ch. 22 - Prob. 4PS Ch. 22 - Real options Describe each of the following...Ch. 22 - Expansion options Look again at the valuation in...Ch. 22 - Expansion options Look again at Table 22.2. How...Ch. 22 - Prob. 8PS Ch. 22 - Timing options Look back at the Malted Herring...Ch. 22 - Prob. 10PS

Solution Summary: The author responds to the statement on whether to use a decision tree rather than using option theories. Discount rates cannot be used for any of the option payoffs.

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