5. Wahal Corporation uses the NPV method when selecting projects, and it does a

Question

5. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers any 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 the failure to consider 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. e. Real options should not have any effect on the size of the optimal capital budget. 5. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers any 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 the failure to consider 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. e. Real options should not have any effect on the size of the optimal capital budget. 5. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers any 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 the failure to consider 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. e. Real options should not have any effect on the size of the optimal capital budget.

Explanation / Answer

Answer is a) Its estimated capital budget is probably too small, because projects' NPVs are often larger when real options are taken into account.

NPV approach generally assumes that the flexibility to alter corporate strategy in view of actual market realizations is ignored while only accounting for future expected cash flows using the discount rate (assuming that the discount rate reflects the embedded risk in the project). Real options, on the other hand, allows management to be active and respond to market changes. More simply, management adapts to negative outcomes by decreasing its exposure and to positive scenarios by scaling up, thereby increasing the benefits realized by the firm. Given these different factors, capital budgeting with taking into account real options would likely lead to a higher NPV.

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