A restaurant is producing net cash flows, after out-of-pocket expenses, of $600,000 per year (forever).There is no upward or downward trend in cash flows, but they fluctuate a lot, following a random walk, with an annual standard deviation of 15%. The hurdle return for the restaurant is 12%. The risk-free rate is 5%. The real estate occupied by the restaurant is owned and can be sold for $5 million and its value is stable. Any decisions by the firm will be acted on in 1 year.

a.Draw the decision tree for this problem with labels.

b. How much is the value of the restaurant without the abandonment consideration?

Put Option

Market price (S)

Strike price (K)

Time in years

Percent Up

Interest rate

Option Price

c. How much is the value of the restaurant with the abandonment consideration?