Finding the value of the option to abandon the project

Reference no: EM131971085

Question: In evaluating a new project with some uncertainty, you decide to consider a real option approach to estimating its cash flows. As the "base case", we are expecting to sell 6,250 units per year for a net cash flow of $145 each for the next 30 years (no taxes). In other words, the expected cash flow is 6,250 x $145 = $906,250. The relevant discount rate is 17% and the initial investment required is $3,800,000.

a) What is the NPV of the base case?

b) After the first year of sales (in the second year), one of two things can happen: If the project is a success, sales for the rest of the project should be revised up to 7,700 units per year (60% chance) but if it is a failure (40% chance), sales should be revised down to 3,500 units per year. What is the NPV of the project now?

c) Now consider if you have the option to abandon the project if it is not a success. If this is the case, you can salvage the assets for $2,500,000 at the end of year 2 but still make 2,000 units in sales throughout the year. Re-calculate the NPV of the project including this option.

d) What is the value of the option to abandon the project?

Reference no: EM131971085

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