Abandonment Options

Herman Co. is considering a four-year project that will require an initial investment of $15,000. 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 $20,000 per year, and the worst-case cash flows are projected to be $1,000 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.

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

1. $16,323

2. $19,588

3. $18,771

4. $17,955

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 $3,000 (at the end of year 2). The $3,000 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 $1,000 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.

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

1. $17,409

2. $22,632

3. $21,761

4. $20,891

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

1. $1,086

2. $923

3. $977

4. $760

5. $1,140