Abandonment Option

CFA Level II Corporate Finance
#1

Pg 250 Schweser Book 2.

Abandonment option:

3 year project; I/Y = 14 %

Expected cash flow $ 400 per year

50 % probability $ 600/yr

50 % probability $ 200/yr

At the end of 1st year , we will know if project is a success ( cash flow 600 ) or failture ( cash flow 200 )

Option to abandon project at end of year and receive salvage value of $ 650.

By abandoning project we receive salvage value of $ 650 but give up cash flows for year 2 and year 3.

Therefore optimal strategy is to abandon the project at the end of the first year if PV of remaining cashflows in years 2 and 3 is less than the salvage value of $ 650

According to Schweser:

If project is success cash flows will be $ 600 at the end of years 2 and 3 and in inputting the numbers to calculate NPV in the calculator. they have used the following values:

N=2; I/Y = 14 ; PMT =600; CPT PV = 988.

This is greater than the salvage value of 650, so the optimal strategy is not to abandon the project if we determine that at the end of the 1st year that it is a success.

If project is failure cash flows will be $ 200 at the end of years 2 and 3 and in inputting the numbers to calculate NPV in the calculator. they have used the following values:

N=2; I/Y = 14 ; PMT =200; CPT PV = 329

This is lesser than the salvage value of 650, so the optimal strategy is to abandon the project if we determine that at the end of the 1st year that it is a failture.

My question is why is N=2 ? I am very confused because , it is end of 1st yr that they calculate NPV.

Help will be dearly appreciated.

#2

Yes it is calculated at the end of the first year since decision has to be taken at the end of the 1st year based on incremental cashflows for the remaining period. Note question states “At the end of 1st year , we will know if project is a success ( cash flow 600 ) or failture ( cash flow 200 )”.

From what I understood there are 3 parts to success/failure type questions based on this example:

1) as to what decision should be taken based on cashflows for residual period under success and failure conditions and then,

2) the NPV calculation for success and failure options where respective cashflows for the entire period is considered. These NPVs when combined with the probability of success & failure will add up to NPV of project with abandonment option.

3) computation of value of the option as (NPV with abandonment option) - (NPV without abandonment option*)

Note-* normal NPV of a project with out success failure conditions

#3

Thank you Brisby and Shark for your very valuable explanations !