What is the value of the abandonment option

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Reference no: EM132068696

Downey textile is evaluating a capital budgeting project that will cost $10million today. The project is of average risk and requires a WACC of 10%. Downey has identified three likely outcomes for the project which it calls the projects best-,base- and worst- case outcomes. The probability of each outcome is 0.25,0.5 and 0.25 respectively. The projects after tax cash flow for each outcome are $5million,$3million and $1million at the end each of the next four years respectively. The NPVs of the best-,base- and worst- case scenarios are $5,849,327.23, $490,403.66 and -$6,830,134.55 respectively. Suppose Downey has the opportunity to quit the project after the first year if it turns out to be following the worst case scenario. Downey will receive $1million cash flow at the end of year one and sell the project fixed assets at $5.1million. No further cashflow will be realized of the worst case scenario happen and the project is abandoned. What is the value of the abandonment option?

Reference no: EM132068696

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