Question

8. Abandonment options Shan 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 $14,000 per year. The best-case cash flows are projected to be $26,000 per year, and the worst-case cash flows are projected to be - $4,500 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 14%? O $25,268 $21,057 O $22,110 $16,846 Shan 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 $3,000 (at the end of year 2). The $3,000 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 -$4,500 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. $31,104 O $21,533 $23,926 $27,515 What is the value of the option to abandon the project?

Answer 1

vear 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 @ 14% Present value - 15000 15000 15000 - 15000 -$15,000 14000 26000 -4500 0.25 0.25 7000 6500 -1125 12375 0.87719 $10,855 14000 26000 -4500 0.25 0.25 7000 6500 -1125 12375 0.76947 $9,522 14000 26000 -4500 0.25 0.25 7000 6500 -1125 12375 0.67497 $8,353 14000 26000 - 4500 0.5 0.25 0.25 7000 6500 -1125 12375 0.59208 $7,327 $21,057 EXPECTED NPV 4 Expected cash flows base case best case worst Probability = cashflows x probability (cash flows) base case best case worst base case best case worst - 15000 15000 15000 1 14000 26000 - 4500 0.5 0.25 0.25 7000 6500 14000 26000 3000 0.25 0.25 7000 6500 14000 26000 0.5 0.25 0.25 7000 6500 14000 26000 0.5 0.25 0.25 7000 6500 - 1125 750 Total expected cash flows pv @ 14% Present value - 15000 $15,000 12375 0.87719 $10,855 14250 0.76947 $10,965 13500 0.67497 $9,112 13500 0.59208 $7,993 $23,926 EXPECTED NPV Value of the option to abandon the project = $2,869) [ 21057-23926] Activate