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Principles of Corporate Finance (11th Edition) See this solution in the app

Problem

True or false?

a. Decision trees can help identify and describe real options.

b. The option to expand increases PV.

c. High abandonment value decreases PV.

d. If a project has positive NPV, the firm should always invest immediately.

Step-by-step solution

True or False:

(a)

Decision trees can help identify and describe real options. This statement is true.

Decision tree technique is a tree-shaped diagrammatic representation of the possible outcomes for a project with probabilities for each action. The technique helps to understand the risk associated with the project and future forecasts.

Decision tree technique provides the options for a project. Hence, decision tree technique is used to describe the real options in capital investment projects.

Comment

(b)

The option to expand increases PV. This statement is true.

Present value refers to the value of cash flows of a project in terms of today. The cash flows are discounted with the cost of capital to get present value. A company having option to grow will add value to the company’s cash flows.

Company will infuse more capital which will lead to increase in cash inflows to cover the investment. This will ultimately increase the present value of cash flows.

Comment

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(c)

High abandonment value decreases PV. This statement is false.

Abandonment value is the liquidation or sales value of an asset or project if sold or liquidated immediately. Selling of as asset is the decision of the management. The management will sell any asset when it finds it not profitable.

Abandonment value is not related to the Present Value (PV) of asset. Hence, high abandonment value does not decrease the present value.

Comment

(d)

If the project has positive NPV, the firm should always invest immediately. This statement is false.

Investment should be done at the time when the investment maximizes the value of the firm. Positive Net Present Value (NPV) does not mean that the firm should invest immediately. Firm should wait as the NPV may increase further which will give better returns.

Firm should take decision about investment after proper scrutiny of the NPV of the firm. Hasty decisions may lead to unpleasant situation in long run. Hence, projects with positive NPV should not invest immediately.

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Chapter 10, Problem 6PS

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