9. Introduction to real options Aa Aa Consider the following statement about rea

Question

9. Introduction to real options Aa Aa Consider the following statement about real options: Sormetimes real options can give managers the flexibility to decide to invest in a project or wait to make a more calculated decision. True or False: The preceding statement is correct. O True O False Which type of real option allows the output and/or inputs in the production process to be altered, depending on how market conditions change during a project's Ife? O Flexibility option O Abandonment option O Investment timing option O Growth option Consider the following example: King Snowplows began operations in New York City tw the majority of its business working for the city. The company also had offers from surrounding cities in and Long 1sland, but these offers would have required the company to invest in additional high up-front costs, King Snowplows decided to purchase only the snowplows n o years ago. As an independent contractor, the company does New Jersey snowplows-which have Snowplows decided to purchase only the snowplows necessary to handle its contract with the additional contracts with the cities in New Jersey and Long Island in the future if it thinks that the additional contracts justify investing in more snowplows 5 6

Explanation / Answer

Part 1)

The preceeding statement is "True".

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Explanation:

With the use of real options, the managers have the flexibility (and not the obligation unlike financial options) to exercise their rights in relation to investment in a project. They have the right to delay a particular project, increase or decrease its scope or completely abandon the project if it not appears to be beneficial. As such, if a project doesn't appear to be favorable now, the managers can wait for a certain period and again reveiw the benefits (cash flows) and take a decision on the acceptance or rejection of the project.

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Part 2)

Flexibility Option (which is Option A)

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Explanation:

Flexibility option is generally considered as options relating to operation of a project. The flexibility to change outputs is termed as "product flexibility" and inputs is termed as "process flexibility". The management can alter the output/input mix depending on market conditions and take advantage of new opportunities resulting from a change in mix.

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Part 3)

Expand is the correct option.

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Explanation:

The option of abandonment is used when the project is decided to be closed because the remaining benefits expected (when discounted to today's value) from the project turn out to be lower than the today's value of the project (liquidation value). However, in case of expand option, the management has the right to accept additional contracts in case the benefits realized are the more than the investment cost. This option gives the company an opportunity to expand as and when things appear to be favorable.

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