A project requires an investment of $380 million and has expected annual cash flows of $25 million in perpetuity, starting in one year. In fact,

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A project requires an investment of $380 million and has expected annual cash flows of $25 million in perpetuity, starting in one year. In fact, future cash flows will be either $81 million or $14 million, in perpetuity.

The company can end the project in 1 year after collecting the first cash flow and thus finding out the amount of future cash flows, and then sell all project assets for $380 million (after taxes).

The appropriate discount rate for the project is 12% and the risk-free rate is 2%.

What is the NPV of the project ignoring the option to abandon (in $ million)?

What should the company do?

Accept the project

Reject the project

Cannot say, need more information

What is the value of the project after one year in the down state without abandonment (in $ million)?

What is the down factor (d) in the binomial option valuation model? Hint: It should be a number between 0 and 1.

What is the risk-neutral probability of the up movement?

What is the option payoff in year 1 in the down state if the company abandons the project after 1 year (in $ million)?

What is the value of the option to abandon (in $ million)?

hat should the company do?

Cannot say, need more information

Start the project, then abandon it after one year

Start the project, then decide about abandonment in one year

Start the project and never abandon it

Never start the project

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