Real options: Option to abandon

Idea: When a project spans multiple periods, new information on the business environment

comes in after it starts. Based on the new information, we learn about the future and can

make decisions accordingly, including possibly abandon the project. As we'll see, some

projects are worth more dead than alive.

Example:

Your first job is CFO of Gump Restaurants Co$.,$ which is considering opening fifteen $(15)$

new restaurants at different locations around California this year. Gump wants to know if

the expansion plan makes sense from a financial standpoint. Gump tells you the following

information:

$--$ All the locations look equally good as of now. The only way to distinguish the good from

the bad is to operate the restaurant for a year.

$--$ Each restaurant costs $$800,000$ to open.

$--$ If a restaurant remains open after the first year, the incremental cash flow from the

location is expected to grow at $3\%$ in perpetuity from its first year level.

$--$ If a restaurant is closed at the end of the first year, the expected salvage value of the

equipment and the reclamation of working capital is $$300,000$ net of the costs of

terminating the lease and employee layoffs, etc.

$--$ Gump's investors require $13\%$ rate of return on their investments.

$--$ Gump provides you with the cash flow performance of the fifteen restaurants that opened

last year. He expects this year's fifteen restaurants to have a same distribution of first$-$year

incremental cash flows, as shown below $($in $$1000).$

Gump has done a straight discounted cash flow analysis based on the information above.

The average present value of expected future cash flows for the fifteen restaurants is