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Real Options and Capital Budgeting

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.

Solution Summary

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