This exercise pertains to the XYZ Company example in the body of the chapter and the associated discussion of real options.

Required

1. Define the term real option. Provide an example of each of the four common types of real options.

2. Define the terms put option and call option. Which of the four common types of real options are similar to put options? Which are similar to call options?

3. Based on the stated probabilities for the individual states of nature (i.e., level of consumer demand):

a. What is the expected value each year of the after-tax cash inflows from the proposed investment, without considering the investment delay option?

b. What is the estimated NPV of the proposed investment, without considering the investment delay option?

4. We see from Panel B of Exhibit 12.11 that XYZ would invest in the project only if the revealed level of consumer demand was high or medium. Show calculations as to why no investment would be made if the revealed level of demand were low.

5. In Panel B of Exhibit 12.11, show for each of the three scenarios the calculation for present value (at t = 0) of cash inflows (cells H20:H22), present value of cash outflows (cells I20:I22), and weighted net present value (cells J20:J22). What is the interpretation of the expected NPV of the project (i.e., a positive $12.95 million)?