Description: Kellogg School of Management

Corporate Finance

Finance II (441)

Professor Matsa

 

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Homework Assignment 4

 

To complete Homework 4, you will answer a series of questions through the web page. The web pages will ask you whether you would like to buy the project. You will click on the yes or no button. The next set of pages will ask you whether you would like to invest (meaning drill wells in the land). Again, you will click yes or no.  Before you complete this assignment, be sure you have read the full instructions for Homework 4 (see below). After you have finished the assignment online, your answers will be transmitted to me electronically; you do not need to hand in any additional answers.

 

Although you will complete the assignment through the web, the underlying program runs on a secure server at Kellogg.  Thus if you are not physically on campus when you complete the assignment, you will need to VPN into the Kellogg network before starting the assignment.  You should have VPN installed on your computer.  If you do not have it or cannot remember how to use it, KIS provides instructions here.

 

Here are a few reminders before you begin:

  1. You should complete the assignment two times.
  2. You will need to enter your NetID and a seven digit ID number (which may be the ID number that the school gave you or any seven digit identifier of your choosing). I will use this number to link your two sets of answers. The computer will mail your answers to your Kellogg email account (so make sure your NetID is correct).
  3. Enter your identifying number very carefully. You will be asked for your section number and a seven digit ID number. Enter this number without hyphens (i.e. 1234567). Do not use the number 1234567 (the computer automatically throws these entries away.) If the NetID, section number, and ID number are not entered correctly, I may not find your submission.
  4. Do not use the back key. If you try to go back, it will crash the simulation. As in life, you can't undo decisions you have already made.
  5. After you complete all 18 cases, a summary of your investments will be displayed. A copy of the summary should be e-mailed to you automatically, but you should make a hard copy just in case it gets "lost in the mail.”

 

When you are ready to complete the assignment, click here.

 

Detailed Instructions

 

Many of the capital budgeting examples considered in finance are quite simplified. We intentionally ignored many facets of reality, so that we can concentrate on one or two issues. Problems in the real world are more complex. This homework assignment is simple relative to many real world situations. This assignment gives you the opportunity to apply what you have learned about capital budgeting and real options to a more realistic, and therefore messier, situation.

This assignment will ask you to make a sequence of capital budgeting decisions. Each time you invest it costs money. However, the project is only successful with a small probability. This problem is more realistic than regular capital budgeting examples from class, in the sense that you do not know the true probability of success with certainty. If the project is successful, you will receive a large payoff. If the project is unsuccessful, the payoff is zero. However, following unsuccessful investments you have the option to invest again. You may continue investing until you are successful or until you decide that it no longer makes sense to continue investing. Assume a zero percent discount rate – i.e., sum the expected cash flows to calculate the NPV.

The final feature of the investment decision is you must decide whether to purchase the rights to the investment project. If you choose to purchase the investment project, you will then be asked whether you want to invest. After each unsuccessful investment round, you will be asked whether you want to invest again. After 30 unsuccessful investments, the program will stop and move you onto the next case. You will need to decide whether you should continue to invest or stop. To make your decisions, you may want to use our discussion of real investment options (Lecture 5), your knowledge of capital budgeting from Finance I, and any experience from your work experience which you think is relevant.

The program will run through eighteen independent examples. In each example, you will be given information on the investment project and asked whether you want to purchase the project. The information will include the purchase price of the project, the cost of each incremental investment, the payoff if the investment is successful, and the distribution for the probability of success. Only the cost of each incremental investment will remain constant across scenarios. It will always be $10. The other numbers will change across the scenarios. You will be told the two possible values of the true probability of success. For example, the probability of a successful investment may be 15% or 25% with equal probability. The actual probability of success will be one of these probabilities and will not change for the duration of the scenario. You, however, will not know which one is correct.1  Each scenario is independent of the others.

When you are finished the computer will store your results along with your NetID. The computer will also ask you for a 7 digit ID number (which may be the end of your social security number or the ID number that the school now uses). Since I cannot post your name with your homework score, I will post your answers by the last six digits of this number on the web page. I will also link your first and second trials using the id number. On your second trial, make sure you enter the same ID number as the first time. If there are problems with the program or you have questions about the assignment, please ask me. You must run the program twice. I will grade you on the correctness of your investment decisions – i.e., did you take positive NPV projects and only positive NPV projects. I will use take the maximum of your two scores in assigning a score for this homework.2

 

Footnotes:

1.    For those of you interested in the mechanics of the program, here is what the computer is doing. The computer will tell you that the true probability of success is 15% or 25% with equal probability, for example. Then the computer will 'flip a coin'. If the coin comes up heads (which happens 50% of the time), it will select 15% as the true probability of success. If the coin comes up tails, it will select 25% as the true probability of success. You don't know what the true probability of success is. If the first coin came up heads, each time you choose to invest an additional time, the computer 'flips another coin' which comes up heads 15% of the time. If the first coin came up tails, each time you choose to invest an additional time, the computer 'flips another coin' which comes up heads 25% of the time.

2.    If you do the homework only once, your score will be one half the score given on your first completion of the assignment. You should do the program exactly twice. I will consider it a violation of the honor code if you complete the homework under a fictitious name.

 

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