Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?
A) $55.08
B) $57.98
C) $61.03
D) $64.08
E) $67.29

Question

Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm? 
A) $55.08 
B) $57.98 
C) $61.03 
D) $64.08 
E) $67.29

Quizplus · Accepted Answer

To find the value of the abandonment option, we need to calculate the expected value of the project with and without the option, and compare the differences.

Without the abandonment option: 
Expected value = (0.2 x $2,000,000) + (0.5 x $1,500,000) + (0.3 x $500,000) - $1,000,000
Expected value = $100,000

With the abandonment option: 
Expected value = (0.2 x $2,000,000) + (0.5 x $1,000,000) - $500,000 
Expected value = $600,000

The difference between the expected values is $500,000 ($600,000 - $100,000), so the option to abandon is worth $500,000 to the firm.

Therefore, the best choice is to proceed with the project and purchase the abandonment option, as it increases the expected value of the project by $500,000. The answer is choice letter C.

Brandt Enterprises Is Considering a New Project That Has a Cost