Discussion Question 1 – CLO 1, CLO 3, CLO 4, CLO 5, CLO 6, CLO 7, CLO 8

Please answer the following questions in detail, provide examples whenever applicable, provide in-text citations.

  • Please describe the real option inherent in each of the following cases and provide some real-life hypothetical cases. Also, explain in each case if the option seller is involved and who that seller might be.

a. Moda di Milano postpones a major investment. The expansion has positive NPV on a discounted cash-flow basis, but top management wants to get a better fix on product demand before proceeding.

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b. Western Telecom commits to production of digital switching equipment specially designed for the European market. The project has a negative NPV, but it is justified on strategic grounds by the need for a strong market position in the rapidly growing, and potentially very profitable, market.

c. Western Telecom vetoes a fully integrated, automated production line for the new digital switches. It relies on standard, less-expensive equipment. The automated production line is more efficient overall, according to a discounted cash-flow calculation.

d. Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane to be switched quickly from freight to passenger use or vice versa.

2. State if each of the following statements is true or false. Justify your answer.

  • Decision trees can help identify and describe real options.
  • The option to expand increases PV.
  • High abandonment value decreases PV.
  • If a project has a positive NPV, the firm should always invest immediately.

3. State if each of the following statements are true or false. Justify your answer.

  • A firm that earns the opportunity cost of capital is earning economic rents.
  • A firm that invests in positive NPV ventures expects to earn economic rents.
  • Financial managers should try to identify areas where their firms can earn economic rents, because they think thatpositive NPV projects are likely to be found in projects that earn economic rent.
  • Economic rent is the equivalent annual cost of operating capital equipment.

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