CHAPTER 12

OTHER TOPICS IN CAPITAL BUDGETING

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Abandonment option Answer: b Diff: E
1. Which of the following statements best describes the likely impact that an
abandonment option will have on a project’s expected cash flow and risk?

a. No impact on expected cash flow, but risk will increase.

b. Expected cash flow increases and risk decreases.
c. Expected cash flow increases and risk increases.
d. Expected cash flow decreases and risk decreases.
e. Expected cash flow decreases and risk increases.

Investment timing option Answer: e Diff: E

2. Commodore Corporation is deciding whether it makes sense to invest in a
project today, or to postpone this decision for one year. Which of the
following statements best describes the issues that Commodore faces when
considering this investment timing option?

a. The investment timing option does not affect the expected cash flows
and should therefore have no impact on the project’s risk.
b. The more uncertainty about the project’s future cash flows the more
likely it is that Commodore will go ahead with the project today.
c. If the project has a positive expected NPV today, this means that its
expected NPV will be even higher if it chooses to wait a year.
d. All of the above statements are correct.
e. None of the above statements is correct.

Flexibility option Answer: c Diff: E N

3. Which of the following is an example of a flexibility option?

a. A company has the option to invest in a project today or to wait a

year.
b. A company has the option to back out of a project that turns out to be
unproductive.
c. A company pays a higher cost today in order to be able to reconfigure
the project’s inputs or outputs at a later date.
d. A company invests in a project today that may lead to enhanced
technological improvements that allow it to expand into different
markets at a later date.
e. All of the statements above are correct.

Chapter 12 - Page 1
Real options Answer: c Diff: E
4. Which of the following is an example of a flexibility option?

a. A company has the option to invest in a project today or to wait a

year.
b. A company has the option to back out of a project that turns out to be
unproductive.
c. A company pays a higher cost today in order to be able to reconfigure
the project’s input or outputs at a later date.
d. A company invests in a project today that may lead to enhanced
technological improvements that allow it to expand into different
markets at a later date.
e. All of the statements above are correct.

Real options Answer: b Diff: E N

5. Whalen Maritime Research Inc. regularly takes real options into account
when evaluating its proposed projects. Specifically, Whalen considers
the option to abandon a project whenever it turns out to be unsuccessful
(the abandonment option). In addition, it usually evaluates whether it
makes sense to invest in a project today or whether to wait to collect
more information (the investment timing option). Assume the proposed
projects can be abandoned at any time without penalty. Which of the
following statements is most correct?

a. The abandonment option tends to reduce a project’s NPV.

b. The abandonment option tends to reduce a project’s risk.
c. If there are important first-mover advantages, this tends to increase
the value of waiting a year to collect more information before
proceeding with a proposed project.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 12 - Page 2