Question 14 of 15 estion 14 2 points Save Ans The Z-90 project being considered

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Question 14 of 15 estion 14 2 points Save Ans The Z-90 project being considered by Steppingstone Incorporated (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z-45, becomes an industry standard. There is a 50% chance that the Z-45 will become the industry standard, in which case the Z-90's expected cash flows will be $110,000 at the end of each of the next 5 years There is a 50% chance that the Z-45 will not become the industry standard, in which case the Z-90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%. Now assume that one year from now SI will know if the Z-45 has become the industry standard Also assume that after receiving the cash flows at t 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t-1 but no cash flows after t-1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option? O $2,075 O $4,067 O $8,945 O $10,745 Question 14 of 15 ) Moving to another question will save this response 31 PM

Explanation / Answer

The cost of the abandonment option is $ 4067.

This is computed as follows

1. Find the cash flows if Z-45 does not become industry standard and project is abandoned.

2. Multiply with probability to get the expected cash flow

3. Find the cash flows if Z-45 becomes industry standard.

4. Multiply with probability to get the expected cash flow

5. Add the two to get total expected cash flows

6. Find the NPV = NPV(12%, Expected cash flows t1 to t5)- Initial cost.

If Z-45 does not become industry standard If Z-45 becomes industry standard Year Initial Cash flows received Probability Expected cash flows Cash flows Probability Expected cash flows Total expected cash flows 0 -250000 1 125000 0.5 62500 110000 0.5 55000 117500 2 0 0.5 0 110000 0.5 55000 55000 3 0 0.5 0 110000 0.5 55000 55000 4 0 0.5 0 110000 0.5 55000 55000 5 0 0.5 0 110000 0.5 55000 55000 NPV $4,066.26

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