5. Your company is considering opening a new store in a newly developed tourist area in Honolulu. If you do not sign the lease on the store today, someone else will, and you will lose the opportunity to open a store there later. There is a clause in the lease that allows you to break the lease at no cost in two years. Including the lease payments, the new store will cost $10,000 per month to operate. Because the building has just recently opened, you do not know what the pedestrian traffic will be. If your customers are mainly limited to morning and evening commuters, you expect to generate $8,000 per month in revenue in perpetuity. If, however, the area becomes a major tourist attraction, you believe that your annual revenues will be doubled (i.e. $16,000). You estimate there is a 50% probability that it will become a tourist attraction. The cost to set up the store will be $400,000. Assume that the cost of capital for the business is 7% APR per year.

1. Compute the NPV without the abandonment option, i.e. the contract requires you to operate beyond year 2

2. Compute the NPV with the abandonment option.

3. What is the value of the option to abandon?