Question

8. Abandonment options Albert Co. is considering a four-year project that will require an initial investment of $12,000. 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 12%? $22,395 $27,664 $26,347 $23,712 Albert 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 $4,500 (at the end of year 2). The $4,500 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. $28,048 $32,255 $29,450 $26,646 What is the value of the option to abandon the project? et?

Answer 1

year Expected cash flows Total expected base case best case worst Probability = cashflows x probability cash flows (cash flows) base case best case worst base case best case worst Ipv @ 12% -12000 - 12000 12000 - 12000 1.0 15000 22000 - 1500 0.25 0.25 5500 -375 12625 0.8929 15000 | 22000 - 1500 0.25 7500 5500 -375 12625 0.7972 15000 22000 -1500 0.25 0.25 7500 5500 -375 12625 0.7118 15000 22000 -1500 -1500 0.5 0.25 0.25 7500 5500 - 375 12625 0.6355 7500 0.25 Present value -$12,000 $11,272 $10,065 $8,986 $8,023 $26,347 EXPECTED NPV Expected cash flows Total expected base case best case worst Probability = cashflows x probability cash flows (cash flows) base case best case worst base case best case worst pv @ 12% 1 - 12000 12000 12000 -12000 1.0 15000 22000 -1500 0.5 0.25 0.25 7500 5500 -375 12625 0.8929 15000 22000 4500 0.25 0.25 7500 7500 5500 1125 14125 0.7972 15000 22000 7500 5500 13000 0.7118 15000 22000 5 0.25 0.25 7500 5500 0 13000 0.6355 Present value $12,000 $11,272 $11,260 $9,253 $8,262 $28,048 EXPECTED NPV 0 Value of the option to abandon the project = $1,701 [ 28048-26347]