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%).You will not know whether it is a hit or a failure until the first year's cash flows are in,i.e.,at t = 1.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%.)
A)-9.15
B)+13.99
C)+23.14
D)01)

Question

Quizplus · Accepted Answer

To find the value of the abandonment option, we need to use the decision tree approach.

First, we calculate the expected cash flows if we proceed with the project:
- If it is a hit: $50 million per year for 3 years = $150 million
- If it fails: $10 million per year for 2 years = $20 million
Expected cash flows = 0.5($150 million) + 0.5($20 million) = $85 million

Next, we calculate the present value of the expected cash flows:
PV of expected cash flows = $85 million / (1.1)^1 = $77.27 million

Then, we calculate the expected present value of the project if we abandon it:
- If we abandon it: we receive $60 million from selling the equipment
- If we proceed and it fails: PV of expected cash flows = $20 million / (1.1)^1 = $18.18 million
Expected PV of abandoning = 0.5($60 million) + 0.5($18.18 million) = $39.09 million

Finally, we calculate the value of the abandonment option:
Abandonment option value = Expected PV of abandoning - PV of expected cash flows - Initial investment
Abandonment option value = $39.09 million - $77.27 million - $80 million = -$18.18 million

Since the abandonment option value is negative, it means that it is better to proceed with the project. Therefore, the best choice is to proceed with the project.

You Are Planning to Produce a New Action Figure Called