Question

1. Suppose you have to choose between two technologies for production of a Wankel engine outboard motor: Technology A uses computer-controlled machinery custom-designed to produce the complex shapes required for Wankel engines in high volumes and at low cost. But if the Wankel outboard does not sell, this equipment will be worthless. Technology B uses standard machine tools. Labour costs are much higher, but the machinery can be sold for $10 million if the engine does not sell. No excel file. Done by hand. Step by Step.

	Payoffs from Producing Outboard ($ millions)
	Technology A	Technology B
Buoyant demand	18.5	18
Sluggish demand	8.5	8

Assume that the present value of the project is $11.5 million at year 0 if Technology A is used.

1. What is the present value in year 0 if Technology B is used, ignoring the abandonment value? The risk-free rate is 7 percent.
2. Calculate the abandonment option value of Technology B. Assume that, if you abandon Technology B, you receive the $10 million salvage value but no operating cash flows.

Answer 1

a) The Present Value of the project is calculated as:

= Net cash flows during the period/(1+risk free rate of return)

So from the above example,

For Buoyant demand =18/1.07=$16.82

For Sluggish demand = 8/1.17=$6.3

b) In the second case, the present value will be calculated as:

For Buoyant demand =(18-10)/1.07 =$7.47

ForSluggish demand = (8-10)/1.07 = $(1.86)