QUESTION: 76 Topic 2: Part 3 Sec Two (63 to 105)

A company is evaluating the possible introduction of a new version of an existing product that will have a 2-year life cycle. At the end of 2 years, this version will be obsolete, with no additional cash flows or salvage value. The initial and sole outlay for the modified product is $6 million, and the company's desired rate of return is 10%. Following are the potential cash flows (assumed to occur at the end of each year) and their probabilities if the product is marketed:

The following interest factors for the present value of $1 at 10% are relevant:
Period 1 .909
2 .826
Assume the company has the real option to abandon the project at the end of Year 1. If the salvage value at that time is $3 million and the desired rate of return remains at 10%, what is the project's net present value?

$878,050
$1,200,550
$2,746,450
$4,454,100

Answer(s): B

Explanation:

If the cash flows at the end of Year I equal $2 million, the expected value of the Year 2 cash flows is only $2 million [(.5 x $0) + (.5 x $4 million)]. If the cash flows at the end of year 1 equal $4 million or$6 million, the expected value of the Year 2 cash flows equals $4 million [(.25 x $6.4 million) + (.75 x $3.2 million)] or $5.75 million [(.4 x $6875 million) + (.6 x $5 million)], respectively. After discounting these expected values to the j end of Year 1,the present values are $1,818,000 (.909 x $2 million) given a $2 million Year I cash flow, $3,636,000 (.909 x $4 million) given a $4 million Year 1 cash flow, and $5,226,750 (.909 x $5.75 million) given a $6 million Year 1 cash flow. Accordingly, the real option of abandonment is preferable if the Year 1 cash flow is $2 million. The $3 million salvage value exceeds the expected value of the Year 2 cash flows discounted to the end of Year 1 in this case only. If the real option of abandonment is exercised only when Year I cash flows equal $2 million, the expected value of the cash flows at the end of Year 1 is $4.9 million{[.3 x ($2 million + $3 million salvage)] + (.4x $4 million) + (.3 x $6 million)}, and the present value of this amount is $4,454,100 (.909 x $4.9 million). The expected value of the cash flows at the end of Year 2 if the real option is exercised only when Year I cash flows equal $2 million is $3,325,000 (.3 x 1.0 x $0) + (.4 x .25 x $4 million) + (.4 x .75 x $3.2 million) + (.3 x .4 x $6.875 million) + (.3 x .6 x $5 million), and the present value of this amount is $2,746,450 (.826 x $3,325,000). Consequently, the NPV with an abandonment option is $1,200,550 ($4,454,100 + $2,746,450 --$6 million initial outlay). This amount is substantially greater than the NPV with no abandonment option.

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QUESTION: 77 Topic 2: Part 3 Sec Two (63 to 105)

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Which of the following is not an example of a real option in a capital budgeting decision?

Abandonment.
Follow-up investment.
Option to wait and learn.
Risk-adjusted discount rates.

Answer(s): D

Explanation:

Real options include such factors as the ability to abandon the project early. the opportunity for follow-up investments or ability' to create new products, the ability' to base additional cash outflows on a wait-and-learn opportunity', or the option to change capacity' during the project. Risk-adjusted discount rates are not real options but are a form of sensitivity' analysis.

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QUESTION: 78 Topic 2: Part 3 Sec Two (63 to 105)

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The relevance of a particular cost to a decision is determined by

Riskiness of the decision.
Number of decision variables.
Amount of the cost.
Potential effect on the decision.

Answer(s): D

Explanation:

Relevance is the capacity of information to make a difference in a decision by helping users of that information to predict the outcomes of events or to confirm or correct prior expectations. Thus, relevant costs are those expected future costs that vary with the action taken. All other costs are constant and therefore have no effect on the decision.

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QUESTION: 79 Topic 2: Part 3 Sec Two (63 to 105)

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Of the following decisions, capital budgeting techniques would least likely be used in evaluating the

Acquisition of new aircraft by a cargo company.
Design and implementation of a major advertising program.
Trade for a star quarterback by a football team.
Adoption of a new method of allocating non-traceable costs to product lines.

Answer(s): D

Explanation:

Capital budgeting is the process of planning expenditures for investments on which the returns are expected to occur over a period of more than 1 year. Thus, capital budgeting concerns the acquisition or disposal of long-term assets and the financing ramifications of such decisions. The adoption of a new method of allocating non-traceable costs to product lines has no effect on a company's cash flows, does not concern the acquisition of long- term assets, and is not concerned with financing. Hence, capital budgeting is irrelevant to such a decision.

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QUESTION: 76 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 77 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 78 Topic 2: Part 3 Sec Two (63 to 105)

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QUESTION: 79 Topic 2: Part 3 Sec Two (63 to 105)

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