Investment Analysis: Value of Abandonment Option

How can we calculate the value of the abandonment option provided by the government?

What is the significance of discounted cash flow (DCF) analysis in determining the value of the abandonment option?

Calculating the Value of Abandonment Option

The value of the abandonment option offered by the government is approximately -$734,408.

To calculate the value of the abandonment option offered by the government, we can utilize discounted cash flow (DCF) analysis. This method allows us to determine the present value (PV) of cash flows under different scenarios and compare them with the option price set by the government.

Firstly, we need to assess the cash flows based on various demand scenarios and probabilities:

• High Demand Scenario:
  • Probability: 20%
  • Cash Flows: $300,000 per year indefinitely
  • Discount Rate: 10%
• Low Demand Scenario:
  • Probability: 80%
  • Cash Flows: $50,000 for two years, followed by either high or low demand
  • Discount Rate: 10%

Further calculation involves:

• Present value of cash flows under high demand scenario: $3,000,000
• Present value of cash flows during two years of low demand: $86,776.86
• Present value of cash flows after two years of low demand: $935,000
• Present value of the abandonment option: $683,013.46

After assessing all parameters, the overall value of the investment amounts to $1,417,421.49. Therefore, the value of the abandonment option is determined by subtracting this value from the option price, resulting in approximately -$734,408.

For a detailed understanding of cash flow analysis, you can explore further resources on the subject.