A project is worth $15 million today without an abandonment option.Suppose the value of the project is either $20 million one year from today (if product demand is high)or $10 million (if product demand is low).It is possible to sell off the project for $13 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.
A)$1.21 million
B)$2.86 million
C)$1.90 million
D)$1.64 million

Question

Quizplus · Accepted Answer

The value of the abandonment option is the difference between the value of the project with the abandonment option and the value of the project without the abandonment option. The value of the project with the abandonment option is the expected value of the project, which is the sum of the probabilities of each outcome multiplied by the value of that outcome. The probability of high demand is 50%, and the probability of low demand is 50%. The value of the project with high demand is $20 million, and the value of the project with low demand is $13 million. Therefore, the expected value of the project is (0.5 * $20 million) + (0.5 * $13 million) = $16.5 million. The value of the project without the abandonment option is $15 million. Therefore, the value of the abandonment option is $16.5 million - $15 million = $1.5 million.

A Project Is Worth $15 Million Today Without an Abandonment