CHAPTER 13

Albert Co. is considering a four-year project that will require an initial investment of $12,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $26,000 per year, and the worst-case cash flows are projected to be $4,500 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%?

$27,666

$26,463

$19,246

$24,057

Albert 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 $3,500 (at the end of year 2). The $3,500 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 $4,500 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.

$27,022

$33,778

$32,426

$24,320

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