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Solution to Chap 20

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Chapter 20 Decision Trees, Real Options, and Other Capital Budgeting Topics
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ANSWERS TO END-OF-CHAPTER QUESTIONS 20-1 a. Real options occur when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life. They are referred to as real options because they deal with real as opposed to financial assets. They are also called managerial options because they give opportunities to managers to respond to changing market conditions. Sometimes they are called strategic options because they often deal with strategic issues. Finally, they are also called embedded options because they are a part of another project. b. Investment timing options give companies the option to delay a project rather than implement it immediately. This option to wait allows a company to reduce the uncertainty of market conditions before it decides to implement the project. Growth options allow a company to expand if market demand is higher than expected. This includes the opportunity to expand into different geographic markets and the opportunity to introduce complementary or second-generation products. It also includes the option (an abandonment option) to abandon a project if market conditions deteriorate too much. Flexibility options allow a company to have flexibility in their operations, such as the flexibility to use different fuels or different types of machinery. c. Decision trees are a form of scenario analysis in which different actions are taken in different scenarios. 20-2 Postponing the project means that cash flows come later rather than sooner; however, waiting may allow you to take advantage of changing conditions. It might make sense,

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