Carlson Inc.is evaluating a project in India that would require a $6.2 million investment today (t = 0).The after-tax cash flows would depend on whether India imposes a new property tax.There is a 50-50 chance that the tax will pass,in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years.If the tax doesn't pass,the after-tax cash flows will be $2,000,000 for 5 years.The project has a WACC of 12.0%.The firm would have the option to abandon the project 1 year from now,and if it is abandoned,the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1.If the project is abandoned,the company would receive no further cash inflows from it.What is the value (in thousands)of this abandonment option?
A)$104
B)$115
C)$128
D)$141
E)$155

Question

Quizplus · Accepted Answer

The abandonment option value is calculated by comparing the NPV of continuing the project versus abandoning it. If abandoned, the firm receives $1.35 million at t=1 plus $4.75 million from selling the property. The NPV of abandoning is calculated using the WACC of 12%. The expected cash flows if continued are calculated based on the probability of the tax passing or not. The difference in NPVs gives the value of the abandonment option, which is $128,000.