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Real Options

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Chapter 13
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Capital Budgeting: Estimating Cash Flow
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and Analyzing Risk
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

13-1 The firm’s FCFs reflect both its past and current investments. Past investments produce current FCFs, but current investments are expected to add to FCF at some future point. Conceptually, a project’s projected cash flows and are expected to contribute that same amount to the firm’s future free cash flows. In practice, project cash flows are analyzed to determine what projects the firm will invest in, and then the sum of those investments, and the cash flows they produce, will in the future be reflected in the firm’s FCFs. If a firm identifies and then invests in positive NPV projects, this will increase the value of its operations as determined by the FCF model. The central issue is analyzing individual projects, and here the key factor is assessing the cash flows. See the BOC spreadsheet model. We go through the model to show how capital budgeting projects are analyzed. In this case, the initial NPV, IRR, and MIRR, all evaluated at the 12% average cost of capital and using the expected input values, indicate that the firm should accept the project. However, the risk analysis as done in the scenario analysis indicates that the project is riskier than average, hence the evaluation should be done with a somewhat higher WACC. Note that firms have two types of assets—-assets-in-place (past investments) and growth opportunities. The FCF projections reflect the results of assets now in place and also its expected future investments from growth opportunities. 13-2 Externalities relate to effects that a given project might have on the firm’s other assets. More broadly, externalities relate to effects within

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