A project is worth $12 million today without an abandonment option.Suppose the value of the project is either $18 million one year from today (if product demand is high)or $8 million (if product demand is low).It is possible to sell off the project for $10 million if product demand is low.Calculate the value of the abandonment option if the discount rate is 5% per year.
A)$1.03 million
B)$0.88 million
C)$1.90 million
D)$5.14 million

Question

Quizplus · Accepted Answer

The abandonment option allows the project to be sold for $10 million if demand is low. Without the option, the project would be worth $8 million in the low-demand scenario. The option adds $2 million in value ($10 million - $8 million) in the low-demand scenario. The expected value of the option is $2 million * 0.5 (probability of low demand) = $1 million. Discounting this back one year at 5% gives $1 million / 1.05 = $0.952 million, which is approximately $1.03 million.

A Project Is Worth $12 Million Today Without an Abandonment