Reference no: EM133275440

You company is evaluating a project which costs $1 million today. With an 80% probability it will succeed and generate a perpetual annual cash ?ow of $200,000. With a 20% probability it will fail and make a perpetual annual loss of $5,000. In the next year, it will become clear whether the project will succeed before the ?rst cash ?ow is realized. Your company has an option to forfeit the on-going project and switch to a back- up project in year one. The back-up plan, if carried out, will cost $250,000, and starting year two, it will generate a perpetual annual cash ?ow of $80,000 with a 60% probability and a perpetual annual loss of $10,000 with a 40% probability. Assume an annual discount rate of 10%. What is the value of this option?