Weird Real Options Question - Help!

CFA Level II
#1

ABC Co is considering expanding service to the Far East region. The project has an initial outlay of $10,000,000 with an expected life of 5 years. Annual after-tax operating cash flows have a 50% probability of being $2,000,000 for the five years and a 50% probability of being $3,000,000. The required rate of return is 18% for this project. The company has an option to abadon the project and receive the abandonment value of $6,000,000 in one year.

The optimal abandonment strategy is to:

a) not abandon in either low or high CF states.

b) abandon if either low or high CF occurs

c) abandon only if low CF occurs.

OK i’ll show you my working. All my working shows that any possible path just destroys value so i picked b

Expected annual after tax operating CF:

0.5 (2,000,000) + 0.5 (3,000,000) = $2,500,000

NPV = -10,000,000 + 2,500,000/1.18^5 = -2,182,072

If high cash flow occurs

-10,000,000 + 3,000,000/1.18^5 = -618,486.93

If high cash flow occurs and abandoned:

-10,000,000 + 6,000,000+3,000,000/1.18^5 = -2,372,881

If low CF occurs and abandoned:

-10,000,000 + 2,000,000 + 6,000,000/1.18 = -3,220,338

Can somebody help please?

#2

I’d go with C. Here’s my reasoning:

NPV (base case) = -2182

NPV (high, not abandoned) = -618 NPV (high, abandoned) = -2372

NPV (low, not abandoned) = -3746 NPV (low, abandoned) = -3220

From this you see that if high cash flows occurs it’s better not to abandon. If low cash flows occurs it’s better to abandon.

Hope it’s clear:)

#3

Thanks for that kobi, I was going to pick c but noticed that the HIGH/NOT ABANDON NPV was still negative.

I don’t see a benefit in this project at all? Why buy an option for this project when even if it had the high cash flows scenario (3m each year) for 5 years it would stil return a negative NPV? haha wtf

What a shit question.

#4

P.s this was their working: another wtf

The optimal abandonment strategy is to abandon the project if the PV of subsequent cash flows is smaller than the abandonment value. If the high cash flow occurs at the end of year 1, four years of higher $3m cash flow has a PV of $8,070185 so you should not abandon. Four years of lower $2,000,000 cash flow has a PV of $5,380,123, so you should abandon the project at the end of year 1 and receive $6,000,000.

It doesn’t look like they even took the initial outlay into consideration. this must be wrong?

#5

Hm… I’d day it’s correct what they wrote as the initial outlay is the same in either case so what we really care about and what makes difference here is what happens next. And this is what they calculated. If we subtructed from our calculations PV of initial outlay and 1st cash flow it would probably lead us to the same conclusions.

#6

thanks for your help much appreciated.