You are planning to produce a new action figure called "Hillary." However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year [i.e., at t = 1]). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50 percent). You will not know whether it is a hit or a failure until the first year's cash flows are in . You have to spend $80 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million once the first year's cash flows are received, calculate the value of the abandonment option. (The discount rate is 10 percent.)
A)−9.15
B)+13.99
C)+23.14
D)0.00

Question

Quizplus · Accepted Answer

The abandonment option allows you to sell the equipment for $60 million after the first year if the project fails. The present value of the cash flows if it fails is $10 million for two years, discounted at 10%, which is $17.36 million. The present value of selling the equipment is $60 million discounted at 10%, which is $54.55 million. The abandonment option value is the difference between abandoning and continuing, which is $54.55 million - $17.36 million = $37.19 million. The expected value without the option is $28.04 million, so the option adds $23.14 million.

You Are Planning to Produce a New Action Figure Called