ok, so it says you have an initial project outlay of 10 mil. 50% chance your after tax op cash flows are 3 mil, 50% chance they’re 2 mil, expected life of project is 5 yrs. r = 18% company has an abandonment option value of 6 mil in 1 year. question asks, for the project, the optimal abandonment strategy is to: a. not abandon in either the low/high CF states b. abandon if either low/high occurs c. abandon only if low CF occurs ok, so i looked at the answer and yes, i agree, if you do the CF’s for the high CF scenario, it works out to higher than the abandonment option. what annoys me about this question- given the project outlay of 10 mil, your NPV of the whole project (i’m assuming no salvage terminal value since none was given) is negative no matter what. so why would you even get into the project in the first place? now yes, looking at the question and looking just at abandonment strategies, i guess you lose LESS if you keep going vs abandon if life is going well, but am i crazy or even with the good cash flow scenario, if you CF0 = -10 and CF1 = 3 FV = 5 R = 18, you’re a loser no matter what. *end annoyance with this q* i should’ve gotten it right and just answered the q, but this bothered me and i stupidly said abandon no matter what. bad girl.
so -10 + 2.5 for 5 years at 18% = -2.18 after 1 year abandon option: -10 + (2.+6)/1.18 = -3.22 so keep going?
what they did is say after 1 yr, good way after a year- you have CF = 3, F = 4, so NPV at 18% = 8.07 and change bad way- you have CF = 2, F = 4, NPV = 5.38… abandonment option worth 6 so abandon if you are on the low track, keep going if you’re at 3 b/c it’s above the abandonment option. that all makes sense and i should’ve gotten it right except i’m an idiot. but if you were in year 0 trying to decide, should i take this project on given the initial cash flow and projections, abandonment option, etc… wouldn’t you reject this project outright and not even get yourself to year 1 and have to make that decision? that’s all i’m wondering. seems silly to have even gotten ourselves to year 1 b/c this project was a loser from the get-go.
I agree, Bani. This question put me off as well. At first I thought they tricked us and I “escaped” the trick. But no! They trick us in tricking ourselves! I think CFA questions are supposed to be clear and not confusing like this one. Lots of BSAS questions put me off…