Professional Documents
Culture Documents
1. Which of the following statements is/are true with respect to survival strategies? < Answer >
I. A company might pursue a non-growth strategy if its non-economic objectives are more important than its
economic objectives.
II. A non-growth strategy is bound to be a corrective strategy.
III. A company can adopt a negative strategy in pursuit of withdrawing from less profitable areas of business.
IV. A corrective strategy cannot be used in conjunction with, or as one component of, a growth strategy.
(a) Only (III) above
(b) Both (I) and (II) above
(c) Both (II) and (III) above
(d) (I), (II) and (III) above
(e) All (I), (II), (III) and (IV) above.
2. Which of the following is not a part of the internal governance groups of a firm? < Answer >
(a) Shareholders
(b) The Board of Directors
(c) Media
(d) Managerial hierarchy
(e) Internal capital markets.
3. Which of the following factors does not figure in when assessing the present value of an investment by the risk< Answer >
adjusted discount rate method?
(a) Projected future cash flows from the investment
(b) Beta of the investment in question
(c) Expected return from the tangency portfolio
(d) Expected return from the equity shares of the firm
(e) Risk free return.
4. Which of the following is used by the ratio comparison approach to the valuation of projects or commercial real< Answer >
estate?
(a) Ratio of total debt to equity
(b) Ratio of total debt to total assets
(c) Ratio of price to earnings
(d) Ratio of net income to revenues
(e) Ratio of revenues to total assets.
5. Which of the following statements with respect to the real options are not true? < Answer >
I. Investment timing option allows the firm to delay the project until at a later point of time when more
information is available.
II Growth options allow the firm to alter operations depending on how the conditions change during the life of
the project.
III. Abandonment options give the firms an option to abandon a project if not profitable.
IV. Flexibility options allow a company to increase its capacity of operation if the market conditions are better
than expected.
(a) Both (I) and (II) above
(b) Both (I) and (III) above
(c) Both (II) and (III) above
(d) Both (II) and (IV) above
(e) (I), (II) and (IV) above.
6. According to the trade-off theory of capital structure, the firm attempts to arrive at a trade-off between which of the< Answer >
following?
(a) Between agency cost and bankruptcy cost
(b) Between agency cost and financial cost
(c) Between bankruptcy cost and financial cost
(d) Between size of the tax shield and bankruptcy costs
(e) Between size of the tax shield and agency cost.
7. Consider the following data relating to a company: < Answer >
I. The cash requirement for the period under consideration is constant and known.
II. Cash expenses are incurred evenly over the period under consideration.
III. There are no transaction costs involved in the conversion of securities into cash.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (II) and (III) above.
23. Jyothi Industries Ltd. has annual sales of Rs.3,65,00,000 (Rs.1,00,000 a day on a 365-day basis). On average, the< Answer >
company has Rs.1,20,00,000 in inventory and Rs.80,00,000 in accounts receivable. The company is looking for
ways to shorten its net operating cycle, which is calculated on a 365-day basis. Its CFO has proposed new policies
that would result in a 20% reduction in both average inventories and accounts receivable. The company anticipates
that these policies will also reduce sales by 10%. Accounts payable will remain unchanged. What effect would
these policies have on the company’s net operating cycle? (Round off to the nearest whole day)
(a) –40 days
(b) –32 days
(c) –27 days
(d) –22 days
(e) –18 days.
24. Which of the following is not a determinant of the capital structure of a company? < Answer >
I. It restricts decision makers from introducing their own risk preference directly into the analysis.
II. It is preferable to use this approach whenever forward prices are available for estimating future cash flows.
III. Under this method, each period’s cash flow can be adjusted separately to account for the specific risk of those
cash flows.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
26. The following information is available about Kun United & Co.: < Answer >
Rs. in crore
Gross Fixed Assets = 75
Accumulated Depreciation = 25
Total current assets = 150
Current liability = 50
EBIT = 30
Working Capital Leverage (WCL) for 20% increase in current assets will be
(a) 0.238
(b) 0.313
(c) 0.588
(d) 0.652
(e) 0.885.
27. M/S Swapna Enterprises Ltd., an Indian company has a subsidiary in Germany and is exposed to the risk of euro< Answer >
weakening and the value of its assets, liabilities, and profit contributions declining in rupee terms in its consolidated
financial statements. The company is exposed to which of the following risks?
(a) Transaction risk
(b) Translation risk
(c) Economic risk
(d) Interest rate risk
(e) Market risk.
28. Which of the following are the tasks to be performed by the risk managers while managing environmental risks? < Answer >
I. According to Wilcox model, the net liquidation value of the firm is the best indicator of the financial health of
the firm.
II. Blum Marc’s failing company model is based on liquidity ratios only.
III. According to the Beaver model, the ratio of cash flow to total debt is the single best predictor of corporate
failure.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
END OF SECTION A
SOURCES OF FUNDS
Owner's Fund
Equity Share Capital (Face Value Rs.10) 599.72 599.72
Share Application Money 0.02 0.00
Preference Share Capital 0.00 0.00
Reserves & Surplus 11,938.95 9,997.88
Loan Funds
Secured Loans 305.99 288.86
Unsecured Loans 1,799.85 658.97
Total 14,644.53 11,545.43
USES OF FUNDS
Fixed Assets
Gross Block 7,407.91 5,169.83
Less : Revaluation Reserve 101.83 103.19
Less: Accumulated Depreciation 1,932.30 1,459.35
Net Block 5,373.78 3,607.29
Capital Work-in-progress 560.11 288.35
Investments 1,803.69 1,265.94
Net Current Assets
Current Assets, Loans & Advances 14,362.30 12,910.99
Less : Current Liabilities & Provisions 7,455.35 6,528.13
Total Net Current Assets 6,906.95 6,382.86
Miscellaneous expenses not written off 0.00 0.99
Total 14,644.53 11,545.43
(6 marks)
3. Excel Products Ltd. is a manufacturer of household goods. Presently it is planning to manufacture an automatic < Answer >
dishwasher. The investment required for manufacturing and marketing the new product is Rs.250 lakh. The
investment-planning horizon is five years at the end of which it is estimated that the project will have a salvage
value of Rs.20 lakh. The projected unlevered operating cash flows from the project are: Rs.200 lakh at the end of
each of the first and second years respectively, and Rs.300 lakh at the end of each of the third, fourth and fifth years
respectively. However these operating cash flows as well as the salvage value are uncertain and the actual unlevered
cash flows may be less than the projections, especially in the later years. The uncertainty of the cash flows is to be
factored in by the certainty equivalent method and the certainty equivalent factors for the various years are as
follows:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1.0 0.90 0.80 0.70 0.60 0.50
• The project enhances the debt capacity of the firm in the first year as well as the second year by Rs.75 lakh,
and in the third, fourth and fifth years by Rs.50 lakh. The interest rate on the borrowings of the company is
expected to be 8% and the tax rate applicable is 36% for the entire investment horizon. The interest rate on risk
free securities is 6%. It is assumed that the company will utilize all its tax shields with certainty.
• You are required to calculate the NPV of the investment.
(7 marks)
Caselet 1
Read the caselet carefully and answer the following questions:
4. The caselet says that the target costing can yield important benefits to the success of the new product/service < Answer >
development efforts. Explain the benefits of target costing.
(7 marks)
5. As mentioned in the caselet, after the determination of target cost, the achievement of the same is central to the < Answer >
success of new products and services. In this context, explain the various steps involved in the process of achieving
the target cost.
(7 marks)
Target costing is different from a simple spending control mechanism, in so far as you determine market-based prices for envelopes of
features based upon market and competitive conditions, in which price/volume relationships are examined, then subtract the required
margin to determine the product or service level target cost. Such aggregate level target costs can be useful in designing your value
delivery processes and determining the relative cost contribution of people, process and technology elements in such a manner to
achieve your target cost before costs are incurred.
Managing target costs can be viewed at a unit level and from the framework of product life-cycle costs, as well as from a portfolio
perspective. It is this central algorithm (market price minus margin = target cost), which contributes to the definition of target costing as
a profit and cost planning system. In this regard, cost becomes a dependent variable.
Target costing can yield important benefits to the success of new product/service development efforts. Target costing also provides a
way for your company to target cost reductions in its major cost categories by focusing on major "design drivers" that influence costs
and on the cost of support processes. Frequently the benefits of such efforts can be applied across product lines.
The most robust target costing processes seamlessly integrate strategic business and profit planning, competitive research and analysis,
market research and customer requirements, research and development, technology advances and product development. These
processes establish product and service strategies, which help to determine market niches, market share objectives and market volumes.
Product portfolio and profit plans developed in business planning cycle can provide strategic summary schedules for product
development, introduction and replacement, and capital investments.
The target costing process is a logical outgrowth of determining the causes of cost and seeking ways to reduce or eliminate those costs
before production costs were incurred, while simultaneously looking to improve quality and customer satisfaction. The target costing
process is based upon systems theory and can be integrated into your New Product Development (NPD) process. It is an important
contributor to NPD success.
Determining the product or service concept and the relevant market niche is the first phase of the process. Key determinants of the
concept include the business focus of the enterprise (strategy articulation), understanding the competitive conditions (competitive
research), understanding customers' preferences as well as economic conditions in relevant markets (market research).
After determining the target cost, achieving target cost is central to the success of new products and services. Key to the process is
creating development plans which interact with the multi-year product and service, profit and cost plans. Design teams focus on the
concurrent design of products or services and processes. Frequent checks of the parameters of the plan based upon anticipated,
simulated and/or actual results are applied during the development process. Design reviews which focus on quality, cost and
profitability are included in the check cycle.
In conclusion, it can be said that although target costing in its simplest form is merely a calculation i.e., market price minus margin;
today's competitive environment can make target costing an indispensable, strategic management technique. It can be successfully
integrated into your current NPD and portfolio management processes to provide your firm with economic and strategic benefits. A key
element to consider is the benefit of abandoning projects, which will not be economically viable in today’s competitive markets, and
focusing typically limited resources on those opportunities, which will provide adequate returns to the company.
Caselet 2
Read the caselet carefully and answer the following questions:
6. What is Enterprise Risk Management (ERM)? What does it aim to achieve? < Answer >
(6 marks)
7. What are the attributes involved in the discipline of managing risk? < Answer >
(5 marks)
A major reason the managers are frustrated with their progress on Enterprise Risk Management (ERM) is because they believe they
don’t have adequate tools. This is particularly the case when it comes to risk modeling, developing probability distributions of
outcomes that represent the uncertainty associated with specific risk factors. Illustration to explain the linkages between risk, risk
management, risk capital and ERM consider the classic statistical example of a cookie jar full of white and black marbles. If there is a
penalty for drawing a black marble from the jar, the draw of a black marble is risk. Risk management seeks to understand the full
penalty for drawing the black marble as well as the likelihood that such a draw will occur. Risk capital calculations assure that if you
draw a black marble or perhaps several in a row, you will survive the events. ERM finds the best way to put your hand into the cookie
jar, so to speak.
ERM, taking the pillars of a Basel II approach, then looks at the interaction of business lines, through dynamic, forward-looking
scenarios and seeks to structure a firm in a manner to maximize its performance relative to its risk appetite. Achieving this requires
both an understanding of how business lines operate as well as how they interact with each other and their competitive space.
ERM would analyze the likely impact on both revenues and capital to determine if the merger made sense. This would then lead to an
analysis of what the optimal combination of the three businesses might be going forward, if any and allocating risk-taking authority
(risk capital) in such a fashion as to maximize the firm's anticipated risk-adjusted performance. It is quite conceivable that the three
entities would produce a better risk-adjusted return for the merged entity if their sizes towards going forward were quite different. In
other words, ERM helps to not only determine if a merger makes sense, but where the combined capital of the three entities is best
deployed.
This is exactly the same analysis that is done at any business with multiple existing business lines. Again, the goals of ERM are no
different than those of existing managerial sciences, but are a vast improvement because of the emphasis on improving the
understanding of one's own business through modeling, discipline and education.
END OF SECTION B
A corporate body can face risks arising out of a variety of sources in the dynamic business environment. In order < Answer >
8
to achieve its objective of maximizing the wealth of the shareholders every corporate body must effectively
manage the risks it faces. Explain the various approaches to risk management that may be adopted by a corporate
body.
(10 marks)
< Answer >
9 Though the use of real options had brought in significant advantages in creating a project, still there exist some
pitfalls in their usage. Discuss.
(10 marks)
END OF SECTION C
END OF QUESTION PAPER
Suggested Answers
Strategic Financial Management (MB361F) : April 2007
Section A : Basic Concepts
1. Answer : (d) < TOP >
Reason : A company might pursue a non-growth strategy if its non-economic objectives are more important
than its economic objectives. Statement (I) is true.
A non-growth strategy is bound to be a corrective strategy. Statement (II) is true.
A company can adopt a negative strategy in pursuit of withdrawing from less profitable areas of
business. Statement (III) is true.
A corrective strategy can be used in conjunction with, or as one component of, a growth strategy.
Statement (IV) is not true.
Hence (d) is the answer.
2. Answer : (c) < TOP >
Reason : Media is part of external governance groups of a firm. Hence (c) is the answer.
3. Answer : (d) < TOP >
Reason : Expected return from the equity shares of the firm does not figure out when assessing the present
value of an investment by the risk adjusted discount rate method.
4. Answer : (c) < TOP >
Reason : Ratio of price to earnings is used by the ratio comparison approach to the valuation of projects or
commercial real estate.
5. Answer : (d) < TOP >
Reason : Investment Timing Option allows the firm to delay the project until at a later point of time when
more information is available.
Growth options allow a company to increase its capacity of operation if the market conditions are
better than expected.
Abandonment Options give the firms an option to abandon a project if not profitable.
Flexibility options allow the firm to alter operations depending on how the conditions change during
the life of the project.
Hence (d) is the answer.
6. Answer : (d) < TOP >
Reason : According to the trade-off theory of capital structure the firm attempts to arrive at a trade-off between
size of the tax shield and bankruptcy costs.
7. Answer : (c) < TOP >
Reason : The above trend shows that the overall capitalization rate first decreased and then increased. This is
according to the traditional approach. According to net income approach, the overall capitalization
rate steadily decreases and reaches a point – but does not increase while according to net operating
income approach, it remains constant. Finally, according to MM approach, the overall capitalization
rate is independent of the degree of leverage.
8. Answer : (d) < TOP >
Reason : Agency cost are cost on account of restriction imposed by creditors on the firm in the form of some
protective covenants. Commission payable by the company to its purchasing and selling agents , the
expenses incurred in distribution of the products of the company, or the dividends paid by the
company does not come under the agency cost.
9. Answer : (d) < TOP >
Reason : Current ratio is defined as the ratio between the current assets and current liabilities. While Quick
Ratio is calculated by dividing current assets minus inventories by current liabilities. Now, among the
components of the current assets, inventories are the least liquid instruments. So, a decreasing quick
ratio and same value of the current ratio implies the increasing volume of inventory, thereby
indicating the decreasing level of liquidity.
10. Answer : (a) < TOP >
Reason : Statement I is not correct. According to Marakon model, a firm’s value is measured by the ratio of its
market value to the book value. Other both statements are correct with respect to different models of
maximizing value of shareholders.
Hence the correct answer is (a).
11. Answer : (b) < TOP >
B(r − g)
Reason : P0 =
K −g
80 ( 0.1 − 0.05 )
70 =
( 0.01x − 0.05 )
= 0.7 x – 3.5 = 4
x = 10.71%.
12. Answer : (b) < TOP >
Reason : Of the given factors, value growth duration only is a value driver as per Alcar Model all other are
financial factor determining firm’s value as per Marakon Model.
13. Answer : (d) < TOP >
Reason : The assumptions of multiple discriminant analysis are :
(1) There are two discrete groups to be analysed
(2) The independent variables can be analysed in a linear manner for discriminating between two
groups.
(3) The values of the variables are distributed normally.
Hence statement III is not an assumption of multiple discriminant analysis. So the correct option is
(d).
14. Answer : (e) < TOP >
Reason: Dutch auction are less riskier to the management than fixed price premium offers. All the shares
repurchased receive a uniform price may induce some shareholders to submit their offers at very low
ask prices to ensure their accepteance in the auction. This would benefit the firm by reducing the final
repurchase price. It eliminates those shareholders who assign relatively lower valuatoins to the stock.
All other options are true with respect to Dutch option tender offer.
15. Answer : (d) < TOP >
O(1 − t)
Reason: Value of B Ltd. = k +B×t
1× 0.65
= 0.10 + 0.35 × 4
= 6.50 + 1.40
= Rs.7.90 crores
16. Answer : (a) < TOP >
Reason : EPS = [(Sales – Variable costs – Fixed costs – Interest ) × (1 – tax rate)] / Number of shares
outstanding.
Step 1: Calculate interest expense.
Amount of debt = 2/3 × 15,00,000 = Rs.10,00,000
Interest expense = 10,00,000 × 0.12 = Rs.1,20,000.
Step 2: Solve for EPS
EPS = 3 = [(12,00,000 – Variable cost – 150,000 – 1,20,000) × (1 – 0.3)]/1,00,000
3 = [(6,51,000 – 0.7 Variable cost)]/1,00,000
3,00,000 = 6,51,000 – 0.7 Variable cost
3,51,000 = 0.7 Variable cost
Variable cost = 3,51,000/0.7= Rs.5,01,428.57
% of Variable cost to Sales = (Rs.5,01,428.57/Rs.12,00,000) ×100 =41.79%.
20. Answer : (e) < TOP >
Reason: Argenti Score Card is classified in three weakness namely defects, mistakes and symptoms.
21. Answer : (c) < TOP >
Reason : Asset turnover of a company is defined as the ratio between the sales value and total assets. High
asset turnover is possible only when a company can generate a high sales volume in comparison to
the amount invested in the fixed assets and current assets.
< TOP >
22. Answer : (c)
Reason : There are two costs involved - Holding costs and transaction costs. Holding costs are in the form of
interest forregone on cash balance held, and trasaction costs are costs incurred in converting
securities into cash. Hence, statement (III) is wrong as there are transaction costs involved in the
converting securities into cash.
Hence, option (c) is the correct answer.
< TOP >
23. Answer : (d)
Reason : Net operating cycle = Inventory conversion period + Receivables collection period – Payables
deferral period
For this problem, we are only interested in the change in the net operating cycle. We may therefore
ignore the payables deferral period, since it is assumed to remain unchanged.
Old operating cycle (ignore payables)
= Rs.1,20,00,000/Rs.1,00,000 + Rs.80,00,000/Rs.1,00,000
= 120 + 80 = 200 days.
New operating cycle = Rs.96,00,000/Rs.90,000 + Rs.64,00,000/Rs.90,000
= 106.67 + 71.11 = 177.78 days.
Change in operating cycle = New operating cycle – Old operating cycle
= 177.78 – 200
= -22.22 days. Round off to 22 days shorter.
24. Answer : (e) < TOP >
Reason : Type of asset financed, product life cycle, current capital structure and credit rating are all direct
determinants of capital structure of a company while the type of raw material used does not have any
direct relationship with it.
25. Answer : (a) < TOP >
Reason : The certainty equivalent approach provides a clear basis for making decisions, because the decision
maker can introduce their own risk preference directly into the analysis. Hence, statement (I) is false.
Whenever there is the availability of the forward prices for estimating the future cash flows it is
preferable to use the certainty equivalent method. Hence, statement (II) is true. Under this method,
each period’s cash flow can be adjusted separately to account for the specific risk of those cash flows.
Hence, statement (III) is true.
Hence, option (a) is the correct answer.
26. Answer : (d) < TOP >
Reason : WCL = CA = CA
TA + ∆CA NFA + CA + ∆CA
Reason : The example given in the question is of translation risk. The risk arises from the translation of
balance sheets and income statements in foreign currencies to the currency of the parent company for
financial reporting purposes.
Hence (b) is the answer.
28. Answer : (e) < TOP >
Reason : All the four tasks have to be performed by the risk managers while managing environmental risks.
29. Answer : (b) < TOP >
Reason : According to Walter model on dividend policy, if the internal rate of return is less then the cost of
capital then the optimal payout ratio is 100%.
30. Answer : (d) < TOP >
Reason : The Wilcox model considers the net liquidation value of the firm as the best indicator of a firm’s
financial health. Blum Marc’s failing company model is based on a set of 12 ratios divided into
liquidity, profitability and variability ratios. The Beaver model identifies the cash flow to total debt as
the single best indicator of a firm’s financial health.
Section B : Problems
384.84 < TOP >
1. a. Net Pr ofit m arg in = = 41.63%
924.54
384.84
Re turn on equity = = 24.15%
1593.25
384.84
EPS = = Rs. 6.55
58.75
1
Dividend pay out ratio = = 15.27%
6.55
Retention ratio = 1-0.1527 = 0.8473
g = ROE × b = 0.2415 × 0.8473 = 20.46%
P/E ratio of the company as on 31st March 2007 = (1 − b )(1 + g ) 0.1527 × 1.2046
= = 17.68
Ke − g 0.215 − 0.2046
The estimated price of share as on 31 March 2007 = 17.68 × 6.55 = 115.8
st
b. As given, the firm will have to issue new shares to finance its growth if it switches to a cent percent payout
policy. The growth rate of dividends tends to decline when the amount of retained earnings decreases every
year. On the basis of the current dividend payout policy, the price of the stock for the subsequent year can be
obtained by multiplying the growth rate of 20.46 percent with the intrinsic value of Rs.115.804, which gives
Rs.139.50. At March 2008, if the number of original shares outstanding is taken to be n1, the market value of
the company shall be Rs 139.50n1.
As per the revised policy, new shares numbering n2 will be issued to compensate for the amount distributed out
of retained earnings. This compensation will be equivalent to the Rs 6.69 (5.55 × 1.2046) per original share
(the difference of Rs. 7.89 and Rs 1.2046), an aggregate loss of Rs 6.69n1. The quantity of the new shares
being n2 and with P1 as the price of the share at 31st March 2008 under the revised policy n2P1 = 6.69n1…(1)
At the same time, as the total value of the firm does not get changed, i.e 139.5n1 = P1(n1 + n2)…(2)
These two equations are to be solved to give the value of P1.
By substituting P1 = 6.69n1/n2 in the other equation, we get,
139.50n1 = 6.69n1/n2 (n1 + n2),
139.50n2 = 6.69(n1 + n2) = 6.69n1+ 6.69n2,
20.855n2 = n1 + n2, n1 = 19.85n2
When this relation between n1 and n2 is again substituted in n2P1 = 6.69n1, we get
n2P1 = 6.69 x 19.85n2, ∴ P1 = Rs 132.80.
c. P/E ratio of the company as on 31st March 2008 = 132.80 / 7.89 = 16.83
∴ 16.83 = 1(1 + g )
0.215 − g
∴ 3.6185 – 16.83g = 1+g
∴ 17.83g = 2.6185
∴ g = 14.69%.
2. Profitability ratios: < TOP >
i. EBDIT/ NET SALES =
for the year 2006 = 3324.98/ 14372.65 = 0.231
for the year 2007 = 4,442.03/ 18421.85 =0.241
ii. OCF/ SALES
= ( Net profit + depreciation + other write offs)/net sales
for the year 2006 = ( 2,477.44 + 283.56 + 0.66)/ 14372.65 = 0.192
for the year 2007 = (3,066.91 + 402.84 +0.99)/ 18421.85 = .188
iii. EBDIT / (TOTAL ASSETS +ACCUMULATED DEPRECIATION) =
for the year 2006 = 3324.98/ (18073.56+1,459.35) = 0.1702
for the year 2007 = 4,442.03 /( 22099.88+ 1932.30) =0.1848
iv. OCF/ TOTAL ASSETS = ( Net profit + depreciation + other write offs) / Total assets
for the year 2006 = (2477.44 +283.56+.66) / 18073.56 = 0.152.
for the year 2007 = 3,066.91 + 402.84 +0.99/22099.88 =0 .157
v. EBDIT / (INTEREST +0.25 DEBT) =
for the year 2006 = 3324.98/ 281.80 = 11.80
for the year 2007 = 4442.03 / 661.21 = 6.71
Balance sheet ratios:
i. NET WORTH / TOTAL DEBT
for the year 2006 = 10597.6 /7475.96 = 1.42
for the year 2007 = 12538.69 / 9561.19 = 1.31
ii ALL OUTSIDE LIABILITIES/ TANGIBLE ASSETS
for the year 2006 = 7475.96 / 18072.58 = 0.414
for the year 2007 = 9561.19 / 22099.88 = 0.43.
< TOP >
3.
Year 1 2 3 4 5
A. Debt capacity (increase) 75 75 50 50 50
B. Interest (@ 8%) 6 6 4 4 4
C. Interest tax shield 3.84 3.84 2.56 2.56 2.56
= B(1 – 0.36)
D. Projected operating cash flows 200 200 300 300 300
E. Certainty equivalent 0.90 0.80 0.70 0.60 0.50
F. CE cash flows = D × E 180 160 210 180 150
G. Total CE operating cash flows = C + F 183.84 163.84 212.56 182.56 152.56
H. CE salvage value = 20 × 0.50 10
I. Total CE cash flows = G + H 183.84 163.84 212.56 182.56 162.56
Though the use of real options had brought in considerable advantages in creating a project, still there exists
some pitfalls in their usage.these pitfalls can broadly be categorized under the following:
- Using the real option analysis when one should not use them.
- Framing a wrong model for the purpose of valuation.
- Using incorrect data and biased judgments in the model.
- Miscalculation in the process of valuation.
a. Using real option analysis when one should not
Real option analysis takes into account a number of assumptions. One basic assumption of real option is
that the relevant uncertainties are random walks and as a result are unforeseeable. Coupled with this, it
also states that the consumer is the price taker, and decision taken by the consumer can change the future
course of the random walk. Such assumptions are in fact violated if there exists a small number of
leading competitors. In this case the decisions may not be random. Each player’s action can influence the
price of all the players who will take decisions with full knowledge of what the possible counter moves
will be for every other player. The other assumption the option theory makes is that the risks of an option
can be hedged away. If hedging is feasible the option will be priced as if it had been hedged, in which
case the risk is risk-free. If it is given that hedging is indeed possible it does not matter whether any one
option is actually hedged or not.
b. Using the wrong real option model
It is easy to wrongly assume that the actual decisions pertaining to the project is “Like” a given real
option model while in reality it is “Unlike” so. Thus picking up a wrong model can be disastrous. Say for
example, if one has assumed that the interest rates are fixed, should it change the decisions to a large
extent if the interest rates were truly variable. If one bases his assumption that the prices of oil and gas
are independent of each other, how can it, in any way, influence the decision if they were linked by some
economic mechanism.
c. Miscalculation in the data inputs
It is important to understand the drivers of the option value in any specific real option model. One needs
to check the model for sensitivity to the associated variables, try to understand how the errors in the
variables could result in based results. Say for example, the value of the call option is increased in the
time to expiry and the volatility of the underlying asset is increased. As far as this is concerned it is
important to note that one has over-estimated the length of the available time, or what could be the
smallest possible estimate one could use for volatility?
d. Getting both the models of the data right, but making mistakes in the solution
It may sometimes happen, that while using the complete mathematical algorithm, one can easily miss an
important variable. While calculating the option value, one may notice that the calculated option values
are exploding towards plus or minus infinity, or are oscillating between the two. The results of option
valuation are sometimes in conflict with common sense approach. Nevertheless, it is important to make
as many logical checks as possible to ensure that these results are commensurate with the economic
rationality.