8. Abandonment options

Herman Co. is considering a four-year project that will require an initial investment of $5,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $26,000 per year, and the worst-case cash flows are projected to be $4,500 per year. The companys analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

1.What would be the expected net present value (NPV) of this project if the projects cost of capital is 11%?

$28,384

$33,393

$26,714

$38,402

Herman now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,750 (at the end of year 2). The $4,750 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the projects assets and the companys $4,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

2. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

$33,150

$36,833

$34,991

$46,041

3. What is the value of the option to abandon the project? (3096, 2752, 3440, 3784, 2236)