You company is evaluating a project which costs $1 million today.

With an 80% probability it will succeed and generate a perpetual annual cash flow of $200,000.

With a 20% probability it will fail and make a perpetual annual loss of $5,000.

In the next year, it will become clear whether the project will succeed before the first cash flow is realized. Your company has an option to forfeit the on-going project and switch to a backup project in year one.

The back-up plan, if carried out, will cost $250,000, and starting year two, it will generate a perpetual annual cash flow of $80,000 with a 60% probability and a perpetual annual loss of $10,000 with a 40% probability.

Assume an annual discount rate of 10%.

What is the value of this option?

Answer rating: 100% (QA)

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