Exogenous price uncertainty and the option to abandon.
Management has gone ahead with the investment in Exhibit T16.1, but the market is very competitive and several competitors are considering abandoning the market. If they do not abandon, price will remain at the current level of ¥30,000/ton in perpetuity. It is equally likely that they will abandon, in which case the price will rise to ¥40,000/ton. Because of labor agreements, management must either produce at capacity or close the brewery, at a cost of ¥2 million. This abandonment cost rises at 10% per year. Assume the plant's abandonment decision does not influence competitors' abandonment decisions, so price uncertainty is exogenous. Other facts are as in Exhibit T16.1.
a. Draw a decision tree that depicts the abandonment decision.
b. Calculate the NPV of abandoning today as if it were a now-or-never alternative.
c. Calculate the NPV (as of t = 0) of waiting one year before making a decision.
d. Decompose option value into intrinsic value and time value. Should this investment be made today, in one year, or not at all?
e. Suppose price will be either ¥50,000 or ¥20,000 with equal probability in one year. How does this increase in endogenous price uncertainty affect option value?
Exhibit T16.1
A proposed plant in China will process soybeans for the local (Chinese new yuan, or ¥) market. The sales price of a ton of processed soy will be determined by a government panel, and will be known with certainty in one year. The plant must decide whether to begin production today or in one year.
The following facts apply to the investment decision.
Initial investmentI0 = ¥20,000,000 (rises at 10% per year)
Expected sales price per tonP0 = ¥50,000 per ton in perpetuity
Actual priceP1 = either ¥40,000 or ¥60,000 with equal probability
Variable production costVC = ¥40,000 per ton
Expected productionQ = 500 tons per year forever
Tax rateTC = 0%
Discount ratei = 10%