Question

The following facts have been assembled to facilitate an analysis of an option to abandon a project currently being considered by Xiaomi Group ltd: Risk-free rate of return 8% Time until decision to abandon is taken 0.64 years PV of cash flows if the project is not abandoned Ksh.415 million Salvage value if abandoned Ksh.480 million

The variance of the projects rate of return is being considered at different levels as follows:

Var-1 3%

Var-2 6%

Var-3 9%

Var-4 12%

Required: Assess the effect of a change in the variance on the Value of the Abandonment Option Using black-Scholes options valuation model.

Answer 1

Using Black-Scholes model, the abandonment option value will be the put option value.

As volatility increases, the value of the abandonment option increases, as well. This is logical since with increase in uncertainty of the project, the option to be able to abandon the project at a later date becomes more valuable.