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In many business decision scenarios, managers faces the dilemma, for example, whether to continue the project or to abandon it, whether to finance a project with debt or equity, etc. How can we apply the knowledge of traditional option pricing techniques in such decisions that involve real impact on the cash flows of a business?

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Tod Thiel
Tod ThielLv2
28 Sep 2019

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(1) In many business decision scenarios, managers faces the dilemma, for example, whether to continue the project or to abandon it, whether to finance a project with debt or equity, etc. How can we apply the knowledge of traditional option pricing techniques in such decisions that involve real impact on the cash flows of a business?

(2) Many academics strongly advocate using real options in valuation of intangible assets. See, for example, this article (Dealing with Intangibles Damodaran.pdf). Although the article does not talk about real options, it shows how tricky it is to value such intangible asset as the company's reputation (or its loss). Nevertheless, this method is not used in practice very often. In your opinion, what are the reasons for not seeing real option valuations of intangibles more often?

Exotic Food Inc., Capital Budgeting Case CASE SUMMARY ExoticFood Inc., a food processing company located in Herndon, VA, isconsidering adding a new division to produce fresh ginger juice.Following the ongoing TV buzz about significant health benefitsderived from ginger consumption, the managers believe this drinkwill be a hit. However, the CEO questions the profitability of theventure given the high costs involved. To address his concerns, youhave been asked to evaluate the project using three capitalbudgeting techniques (i.e., NPV, IRR and Payback) and present yourfindings in a report. CASE OVERVIEW The main equipment required isa commercial food processor which costs $200,000. The shipping andinstallation cost of the processor from China is $50,000. Theprocessor will be depreciated under the MACRS system using theapplicable depreciation rates are 33%, 45%, 15%, and 7%respectively. Production is estimated to last for three years, andthe company will exit the market before intense competition sets inand erodes profits. The market value of the processor is expectedto be $100,000 after three years. Net working capital of $2,000 isrequired at the start, which will be recovered at the end of theproject. The juice will be packaged in 20 oz. containers that sellfor $3.00 each. The company expects to sell 150,000 units per year;cost of goods sold is expected to total 70% of dollar sales.Weighted Average Cost of Capital (WACC): Exotic Food’s common stockis currently listed at $75 per share; new preferred stock sells for$80 per share and pays a dividend of $5.00. Last year, the companypaid dividends of $2.00 per share for common stock, which isexpected to grow at a constant rate of 10%. The local bank iswilling to finance the project at 10.5% annual interest. Thecompany’s marginal tax rate is 35%, and the optimum target capitalstructure is: Common equity 50% Preferred 20% Debt 30% Your maintask is to compute and evaluate the cash flows using capitalbudgeting techniques, analyze the results, and present yourrecommendations whether the company should take on the project.What is the Weighted Average Cost of Capital (WACC)? Compute theafter-tax cost of debt Compute the cost of common equity Computethe cost of preferred stock Compute the Weighted Average Cost ofCapital (WACC) Using a WACC of 15%, apply four capital budgetingtechniques to evaluate the project, assuming the Free Cash Flowsare as follows: Years Free Cash Flows 0 $ -252,000.00 1 $118,625.002 $127,125.00 3 $181,000.00 The four techniques are NPV, IRR, MIRR,and discounted Payback. Assume the reinvestment rate to be 8% forthe MIRR. Also, assume that the business will only accept projectswith a payback period of two and half years or less.

Question 1

In a world with no frictions (taxes, etc.), value is created by how you finance a project.

Your Answer

False. True.

Question 2

(5 points) The return on equity is equal to the return on assets of a project/firm.

Your Answer

Never true.

Always true.

Sometimes true.

Question 3

Suppose the expected returns on equity of two firms, Macrosoft and Microsoft, that operate in the same industry are 10.50% and 12.60%, respectively. What is the return on assets in this business if Macrosoft has no debt? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 4

Suppose CAPM holds, and the beta of the equity of your company is 2.00. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 4.5% and the risk-free rate is 3.00%. Suppose the debt-to-equity ratio of your company is 20% and the market believes that the beta of your debt is 0.20. What is return on assets of your business? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 5

You are planning on opening a restaurant chain. You have projected yearly cash flows of $10 million starting next year (t = 1) with a growth rate of 1% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar restaurant businesses equity has an average beta of 1.20 and the average debt-to-value ratio in this industry is 25%. The risk-free rate is 3.25% and the expected market risk premium (the average difference between between the market return and the risk-free rate) is 4.50%. What is the value of the cash flows of your business?

Your Answer Score Explanation

Do not have enough information to calculate.

158730159.

130718954.

Question 6

You have just returned to your job after completing your MBA, generously funded by the CEO. A few days later, your CEO requests you to evaluate the following news release he will issue to analysts. "For years we have thought about our business strategy, without worrying about financing. Times have changed and we need to think about our cost of capital. Since (a) debt is always cheaper than equity; (b) we have decided to use debt to finance our next major projects." What is your assessment of this statement?

Your Answer

The statement is false.

The statement is true.

The statement is partly true/false.

Question 7

Two firms, Alpha, Inc., and Beta, Inc., are in the same business. Alpha, Inc., has debt that is viewed by the market as risk-less with a market value of $500 million. Beta, Inc., has no debt. Both firms are expected to generate cash flows of $100 million per year for the foreseeable future and the market value of the equity of Beta, Inc is $1 billion. Estimate the return on equity of Alpha, Inc. Assume there are no taxes, and the risk-free rate is 5%. (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

Question 8

Mango, Inc. has had debt with market value of $1 million that has paid a 6% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $2 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 20%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.)

Answer: _____________________

Question 9

Suppose all investors are risk-averse and hold diversified portfolios. You are evaluating a new energy company that is going to use wind and will have two divisions: an electricity production unit and a Sales unit. [Transportation of the electricity will be outsourced.] Your CEO and you are arguing about whether projects that emerge in the two units should have the same cost of capital (WACC), or whether the discount rates should be different. If different, what should be the relative magnitudes of the discount rates, that is, which unit Production or Sales should have the higher discount rate. Assume the discount rates of the two units are labeled as P and S, for the production and Sales units, respectively. What do you think?

Your Answer

S>P.

P>S.

Same discount rates for both divisions/units (P=S).

Question 10

NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.25, 2.50, 2.75, and 3.00; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.21, 0.42, 0.63, 0.83. Although these D/E ratios vary, all airline debt is rated the same. Suppose the yield on airline debt is 7%, the risk-free rate is 3% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 5%. What is the cost of capital (or discount rate) that you should use in valuing NorthSouth Airlines? (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13.97% you should enter it as 13.97 NOT 0.14 nor 14)

Answer: _____________________

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