Abandonment option: Use the same information for Question 15 and 16. 15. ABC is

Question

Abandonment option: Use the same information for Question 15 and 16. 15. ABC is considering a project that has an up-front cost of $500,000. There is a 60 percent chance that the products will become the industry standard, in which case the project's expected cash flows will be $200,000 at the end of each of the next five years. There is a 40 percent chance that the products will not become the industry standard, in which case the project's expected cash flows will be $70,000 at the end of each of the next five years. Assume that the cost of capital is 12 percent. 16. Now assume that one year from now ABC will know if its products will standard. Also assume that after receiving the cash flows at t- 1, the company has the option to abadon the project. If it abandons the project it will receive an additional $300,000 at t- 1, but will no longer receive any cash flows after t- 1. Assume that the abandonment option does not affeet the cost of capital (WACC-12% . what is the estimated value of the abandonment option? 1, the company has the option to abandorn +3 221,533

Explanation / Answer

15) Your thinking process seems correct with this one as you would compute NPVs in both situations -

Cumulative PVF@12%

PV of Cash Flows

(c = a x b)

NPV

(e = c - d)

Expected NPV

(e x f)

And your answer is also correct for this one.

16) Now, the company would like to abandon the project only if the product does not become the industry standard which has a 40% chance. Also, it will be receive $300,000 in addition to the first year cash flows which will be $70,000 if the product does not become industry standard. So, the present value of abandonment option would be the cash flows received at the end of year 1 multiplied by the present value factor @12% -

PV of abandonment option = ($300,000 + $70,000) x 0.40 x 0.89285714285 = $132,143.86

NPV of abandonment option = $132,143.86 - $500,000 x 0.40 = (-)$67,856.14

NPV with abandonment option = $132,573.14 - $67,856.14 = $64,717

Therefore, the company should opt the abandonment option as the NPV would be more in this situation.

NPV Probability (f) Cash Flows (a) Years

Cumulative PVF@12%

(b)

PV of Cash Flows

(c = a x b)

Cash outflow (d)

NPV

(e = c - d)

Expected NPV

(e x f)

0.60 $200,000 1-5 3.60477620228 $720,955.24 $500,000 $220,955.24 $132,573.14 0.40 $70,000 1-5 3.60477620228 $252,334.33 $500,000 (-)$247,665.67 (-)$99,066.27 Total $33,506.87

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