Question

A firm is considering a three-year project that will require an initial investment of $100 million. The success of the project depends largely on the future state of the economy. If the economy turns out to be “average,” the project will generate annual cash flows of $50 million during Years 1 through 3. If the economy “booms,” the project will generate annual cash flows of $80 million in Years 1 through 3. If the economy goes into “recession,” the project will generate cash flows of only $20 million in Years 1 through 3. There is a 50% chance that the economy will be “average,” a 25% chance that it will “boom,” and a 25% that it will go into “recession.” The discount rate is 10%.

If the economy goes into recession, in Year 1 (after the Year 1 cash flow occurs) the firm will have the option to abandon the project and sell the project’s assets for an after tax-salvage value of $60 million.

1.What is the NPV of the project, after accounting for the abandonment option? Round your final answer to the nearest million dollars.

a. 28 mil b.30 mil c. 26 mil d.32 mil 3.24 mil

2.What is the value of the embedded abandonment option? Round your final answer to the nearest million dollars.

a. 4 mil b.12 mil c.8 mil d.6 mil e.10 mil

Answer 1