Reference no: EM132812978

Question - Shelley is about to make an investment in a risky project on January 1, 2015. It might turn out well (PV of $2,000) or it might turn out poorly (PV of $0). The 'might turn out well' outcome has a Present Value of $2,000, representing an annuity of high payoffs. The 'might turn out poorly' outcome has a Present Value of $0, representing a zero payoff.  It's a 50/50 chance of either result, and on January 1, 2015 immediately after making the investment Shelley discovers which payoff she gets.

If it turns out poorly, then there is an immediate opportunity to change to a different project that has a PV of $1,000 as of January 1, 2015.

I understand that I haven't provided a discount rate or lots of other details that you might like to have.

Required -

1. Why is it useful to have a backup plan for risky investments? 

2. With the numbers given, what is the value of the option to abandon the original plan as of January 1, 2015?

3. What is the role of accounting in deciding whether to abandon a project? Maybe not here, because we make all of our decisions instantly on January 1, 2015, but say in a situation where we make an investment and then over the next few quarters the accounting reports compute our profits.