Payoffs from Producing Outboard ($ millions)

Technology A

Technology B

Buoyant demand

18.5

18

Sluggish demand

8.5

8

Consider the data given in the previous question. We will assume that Technology A has a salvage value of $7 million, rather than zero. The present value of the project with Technology A is $11.5 million at year 0, assuming no abandonment. The risk-free rate is 7 percent.

1. Construct a one-year binomial tree for this project, with one up or down step every three months (four steps in total). The up steps are +25 percent, the down steps are -16.7 percent.

1. Suppose abandonment can only occur at year 1. In what circumstances would you abandon then? What is abandonment value at year 0?