8. Abandonment options

Shan 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 $12,000 per year. The best-case cash flows are projected to be $19,000 per year, and the worst-case cash flows are projected to be $3,000 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.

What would be the expected net present value (NPV) of this project if the projects cost of capital is 14%?

$27,759

$22,931

$21,724

$24,138

Shan 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 $4,000 (at the end of year 2). The $4,000 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 $3,000 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.

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

$33,043

$27,756

$29,077

$26,434

What is the value of the option to abandon the project?