Question

1. Understanding what the net present value (NPV) tells us.
   • The NPV decision rule says to accept the project if the NPV is greater than zero. You perform a thorough capital budgeting analysis on a project that requires a $1,000,000,000 initial investment and calculate the net present value (NPV) as $1. Following the rule, you tell your boss she should accept the project. She laughs and says “do you think I would really invest $1,000,000,000 for a measly $1 NPV? You should be fired” How would you respond to her?
     
     
2. Real Options
   • Give two examples of “real options” that you have come across in your professional life, or that may come up in projects in a business you wish to start, or that may come up in the projects at a company in which you hope to be employed.

Answer 1

Answer for Understanding what the net present value (NPV) tells us

Objective of any capital budgeting decision is to maximise net present value of the projects and thus create wealth for the shareholders of the firm. Even $1 NPV by investing $ 1 billion, theoretically speaking, is creating value and thus should not be abandoned if no higher alternate projects are present.

Answer for Real options

Real options are the ones that allows business managers to take decisions that change the value of capital budgeting decisions made in the past or today. This may improve the NPV of the project.

Eg 1: Timing option - allows delay in taking the project decision and investing capital with hope getting better information about how the project is going to pan in the future.

Eg 2: Business Expansion Option - it is like a call option on a stock. This option allows managers to to make additional investments in the project if doing so improves the NPV of the project, without additional costs or increasing price of the product.