OklahomaOklahoma Instruments (OI) is considering a project called F-200 that has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, F-100, becomes an industry standard. There is a 50% chance that the F-100 will become the industry standard, in which case the F-200's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the F-100 will not become the industry standard, in which case the F-200's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.
-Refer to Scenario: Oklahoma.Now assume that 1 year from now OI will know if the F-100 has become the industry standard.Also assume that after receiving the cash flows at t = 1,OI has the option to abandon the project,in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1.Assuming that the cost of capital remains at 12%,what is the estimated value of the abandonment option?
A)$2,075
B)$4,067
C)$8,945
D)$10,745

Question

Quizplus · Accepted Answer

The abandonment option is worth $8,945. This is because if the F-100 does not become the industry standard, then the project will be abandoned at the end of year 1 and OI will receive $100,000. The present value of this cash flow is $8,945.

OklahomaOklahoma Instruments (OI) Is Considering a Project Called F-200 That