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You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-Assume that it will cost $1 million to shut down the plant,but you are able to sell the plant for $5 million at any time.The value of the option to sell the plant will be closest to:
A)$3.0 million.
B)$6.0 million.
C)$5.0 million.
D)$0.5 million.

Question

Quizplus · Accepted Answer

The value of the option to sell the plant is the difference between the value of the plant with the option to sell and the value of the plant without the option to sell. The value of the plant with the option to sell is the greater of the value of the plant if revenues increase by 20% and the value of the plant if revenues decrease by 25%. The value of the plant if revenues increase by 20% is $2.4 million, and the value of the plant if revenues decrease by 25% is $1.5 million. Therefore, the value of the plant with the option to sell is $2.4 million. The value of the plant without the option to sell is the present value of the future cash flows from the plant. The future cash flows from the plant are $400,000 per year (revenues of $2 million minus costs of $1.6 million). The present value of these cash flows is $4 million. Therefore, the value of the option to sell the plant is $2.4 million - $4 million = $0.4 million.

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