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Chapter 12 Real Options 12-1 a. Real options occur when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life. They are referred to as real options because they deal with real as opposed to financial assets. | Chapter 12 Real Options ANSWERS TO END-OF-CHAPTER QUESTIONS 12-1 a. Real options occur when managers can influence the size and risk of a project s cash flows by taking different actions during the project s life. They are referred to as real options because they deal with real as opposed to financial assets. They are also called managerial options because they give opportunities to managers to respond to changing market conditions. Sometimes they are called strategic options because they often deal with strategic issues. Finally they are also called embedded options because they are a part of another project. b. Investment timing options give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project. Capacity options allow a company to change the capacity of their output in response to changing market conditions. This includes the option to contract or expand production. Growth options allow a company to expand if market demand is higher than expected. This includes the opportunity to expand into different geographic markets and the opportunity to introduce complementary or second-generation products. It also includes the option to abandon a project if market conditions deteriorate too much. c. Decision trees are a form of scenario analysis in which different actions are taken in different scenarios. 12-2 Postponing the project means that cash flows come later rather than sooner however waiting may allow you to take advantage of changing conditions. It might make sense however to proceed today if there are important advantages to being the first competitor to enter a market. 12-3 Timing options make it less likely that a project will be accepted today. Often if a firm can delay a decision it can increase the expected NPV of a project. 12-4 Having the option to abandon a project makes it more likely that the project will
