Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios.The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties.How much is the option to abandon worth to the firm?
A) $55.08
B) $57.98
C) $61.03
D) $64.08
E) $67.29

Question

Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios.The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties.How much is the option to abandon worth to the firm? 
A) $55.08 
B) $57.98 
C) $61.03 
D) $64.08 
E) $67.29

Quizplus · Accepted Answer

To determine the value of the abandonment option, we need to calculate the present value of the expected cash flow at the end of Year 1 if the firm chooses to abandon the project minus the cost of the abandonment payment.

Under Scenario 1 (Probability: 0.2), the expected cash flow at the end of Year 1 is $50,000. Therefore, the present value of this cash flow at the beginning of the project (Year 0) is $50,000 / (1 + 0.08) = $46,296.30. If the firm chooses to abandon the project, it would have to make an abandonment payment of $800,000. Therefore, the value of the abandonment option under Scenario 1 is: 
$46,296.30 - $800,000 = -$753,703.70 (Note that this is a negative value because abandoning the project under Scenario 1 would result in a net loss for the firm, even after considering the abandonment payment.)

Under Scenario 2 (Probability: 0.5), the expected cash flow at the end of Year 1 is $200,000. Therefore, the present value of this cash flow at the beginning of the project (Year 0) is $200,000 / (1 + 0.08) = $185,185.19. If the firm chooses to abandon the project, it would have to make an abandonment payment of $600,000. Therefore, the value of the abandonment option under Scenario 2 is: 
$185,185.19 - $600,000 = -$414,814.81

Under Scenario 3 (Probability: 0.3), the expected cash flow at the end of Year 1 is $500,000. Therefore, the present value of this cash flow at the beginning of the project (Year 0) is $500,000 / (1 + 0.08) = $462,962.96. If the firm chooses to abandon the project, it would have to make an abandonment payment of $400,000. Therefore, the value of the abandonment option under Scenario 3 is: 
$462,962.96 - $400,000 = $62,962.96

To determine the overall value of the abandonment option, we must weight the value of the option under each scenario by its probability and add the results together:

(0.2 x -$753,703.70) + (0.5 x -$414,814.81) + (0.3 x $62,962.96) = -$607,962.96

Therefore, the value of the abandonment option is -$607,962.96. However, this is a negative value, indicating that the abandonment option is actually a cost to the firm. The firm would be better off not exercising the abandonment option and sticking with the project.

The best choice, therefore, is not to abandon the project. So the answer is: 
Answer: None

Brandt Enterprises Is Considering a New Project That Has a Cost