In Section 10-4 we considered two production technologies for a new Wankel-engined outboard motor. Technology A was the most efficient but had no salvage value if the new outboards failed to sell. Technology B was less efficient but offered a salvage value of $17 million.

Visit us at www.mhhe.com/bma Visit us at www.mhhe.com/bma Chapter 22 Real Options 575 Figure 10.5 shows the present value of the project as either $24 or $16 million in year 1 if Technology A is used. Assume that the present value of these payoffs is $18 million at year 0.

a. With Technology B, the payoffs at year 1 are $22.5 or $15 million. What is the present value of these payoffs in year 0 if Technology B is used? ( Hint: The payoffs with Technology B are 93.75% of the payoffs from Technology A.)

b. Technology B allows abandonment in year 1 for $17 million salvage value. You also get cash flow of $1.5 million, for a total of $18.5 million. Calculate abandonment value, assuming a risk-free rate of 7%.

AppendixLO1