Question

Quantitative Problem

Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. It is considering the introduction of a “weight loss” smoothie. The project would require a $2 million investment outlay today (t = 0). The after-tax cash flows would depend on whether the weight loss smoothie is well received by consumers. There is a 30% chance that demand will be good, in which case the project will produce after-tax cash flows of $1.5 million at the end of each of the next 3 years. There is a 70% chance that demand will be poor, in which case the after-tax cash flows will be $0.5 million for 3 years. The project is riskier than the firm’s other projects, so it has a WACC of 15%. The firm will know if the project is successful after receiving first year’s cash flows. After receiving the first year’s cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t = 1, but it will be able to sell the assets related to the project for $1.5 million after taxes at t = 1.

What is the value of the abandonment option (in millions)? Round your answer to two decimal places.

Answer 1

Smoothies	0	1	2	3
Cash Flows	-2	1.5	1.5	1.5
NPV (good)	$1.42
Cash Flows	-2	0.5	0.5	0.5
NPV (poor)	-$0.86
Expected NPV	-$0.173

Without the abandonment option,

Expected NPV = 30% x 1.42 + 70% x -0.86 = -0.173

Smoothies	0	1	2	3
Cash Flows	-2	1.5	1.5	1.5
NPV (good)	$1.42
Cash Flows	-2	2
NPV (poor)	-$0.26
Expected NPV	$0.245

Now, with the abandonment option,

Expected NPV = 30% x 1.42 + 70% x -0.26 = $0.245

=> Value of abandonment option = Change in expected NPV = $0.418 million