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Abandonment option: Consider a 3-year project with a 14.00% cost of capital. The initial investment is...

Abandonment option: Consider a 3-year project with a 14.00% cost of capital. The initial investment is $1,000 and the expected cash flows are $400 per year.

a. Calculate NPV and determine whether or not to undertake this project.

b. Suppose instead that we have more information on the expected cash flows. First, there is a 40.00% probability that the project is a success and the cash flows will be $700 and a 60.00% probability that the project is a failure and the cash flows will be $200. In addition, at the end of the first year, we will know whether the project is a success or a failure. We have the option to abandon the project at the end of the first year and receive the salvage value of $850. First, determine the optimal abandonment strategy. Then calculate the project's NPV and the value of the abandonment option using that strategy

Requirement:

What is the value of Abandonment option?

Solutions

Expert Solution

(a) NPV = Present value of cash inflow - initial investment

=[ 400/(1+0.14) + 400/(1+0.14)² + 400/(1+0.14)³ ] - 1000

= [ 350.88 + 307.78 + 269.99 ] - 1000

= 928.65 - 1000

= - 71.35

Since NPV is negative therefore do not undertake this project.

(b) Evaluation at the end of first year :

Situation-1: If project is sucessful i.e. cash inflow = 700

Present value of expected cash inflow at the end of first year = 700/(1+0.14) + 700/(1+0.14)²

= 614.04 + 538.63

= 1152.67

Since present value of expected cash inflow at the end of first year (i.e. 1152.67) is more than Salvage Value at the end of first year (i.e. 850) therefore abandonment option should not be opt.

Situation-2: If project is fail i.e. cash inflow = 200

Present value of expected cash inflow at the end of first year = 200/(1+0.14) + 200/(1+0.14)²

= 175.44 + 153.89

= 329.33

Since present value of expected cash inflow at the end of first year (i.e. 329.33) is less than Salvage Value at the end of first year (i.e. 850) therefore abandonment option should be opt.

Hence revised NPV = [ (700+1152.67) 0.40 + (200+850) 0.60 ] / (1 + 0.14) - 1000

= [ 1852.67 0.40 + 1050 0.60 ] / (1 + 0.14) - 1000

= [ 741.068 + 630 ] / (1 + 0.14) - 1000

= 1371.068 / (1 + 0.14) - 1000

= 1202.69 - 1000

= 202.69

Since Revised NPV is positive therefore undertake the project with abandonment option.

Therefore value of Abandonment Option = Revised NPV - Original NPV

= 202.69 - (- 71.35)

= 202.69 + 71.35

= 274.04

jeff jeffy answered 1 year ago

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