Question

8. Abandonment options

Galbraith Co. is considering a four-year project that will require an initial investment of $15,000. The base-case cash flows for this project are projected to be $15,000 per year. The best-case cash flows are projected to be $22,000 per year, and the worst-case cash flows are projected to be –$1,500 per year. The company’s analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

What would be the expected net present value (NPV) of this project if the project’s cost of capital is 11%?

$26,586

$24,169

$19,335

$22,961

Galbraith now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,000 (at the end of year 2). The $4,000 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project’s assets and the company’s –$1,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

$23,225

$30,967

$28,387

$25,806

What is the value of the option to abandon the project?     

Answer 1

Option , $24169

	Cash flows			Probability			Expected cash flows			Total cash flows	PV @11%	Present value of cash flows
	Base case	Best case	Worst case	Base case	Best case	Worst case	Base case	Best case	Worst case
0	15000									-15000	1	-15000
1	15000	22000	-1500	0.5	0.25	0.25	7500	5500	-375	12625	0.9009009	11373.87387
2	15000	22000	-1500	0.5	0.25	0.25	7500	5500	-375	12625	0.8116224	10246.73322
3	15000	22000	-1500	0.5	0.25	0.25	7500	5500	-375	12625	0.7311914	9231.291189
4	15000	22000	-1500	0.5	0.25	0.25	7500	5500	-375	12625	0.658731	8316.478549
												24168.377

Option - $25,806

	Cash flows			Probability			Expected cash flows			Total cash flows	PV @11%	Present value of cash flows
	Base case	Best case	Worst case	Base case	Best case	Worst case	Base case	Best case	Worst case
0	15000									-15000	1	-15000
1	15000	22000	-1500	0.5	0.25	0.25	7500	5500	-375	12625	0.9009009	11373.87387
2	15000	22000	4000	0.5	0.25	0.25	7500	5500	1000	14000	0.8116224	11362.71407
3	15000	22000	0	0.5	0.25	0.25	7500	5500	0	13000	0.7311914	9505.487957
4	15000	22000	0	0.5	0.25	0.25	7500	5500	0	13000	0.658731	8563.502664
												25805.579

Value of the option = 1637.202 [ 25805.579- 24168.377]