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Real Options and Capital Budgeting

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Cash Flow Estimation/Risk Analysis

A) Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity costs and externalities should be included.

Real Options

B) In general, do timing options make it more or less likely that a project will be accepted today?

Capital Budgeting

C) When two mutually exclusive projects are being compared, explain why the short-term project might have the higher ranking under the NPV criterion if the cost of capital is high, however, the long-term project might be considered better if the cost of capital is low.

Please note that a short-term project refers to a project whose cash flows come sooner (in earlier years) than those of a long-term project. The inquiry asks why, assuming all other factors are equal, the short-term project might have a higher ranking when the cost of capital used in the NPV calculation is high and vice versa. Associate this with the discounting process and how a low and then a high discount rate will affect the present values of cash flows of different periods.

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Solution Summary

The real options and capital budgeting is examined for cash flow estimations and risk analysis.

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