PFL is already in production of Fertilizer is considering a proposal of building a new plant to produce pesticides. The Net Present Value of…

CA Final · Advanced Financial Management · MTP · November 2024
PFL is already in production of Fertilizer is considering a proposal of building a new plant to produce pesticides. The Net Present Value of proposal is 200 crore without the abandonment option. However, if market conditions for pesticide turns out to be favourable the NPV of proposal shall increase by 30%. On the other hand, market conditions remain sluggish the NPV of the proposal shall be reduced by 40%. In case company is not interested in continuation of the project it can be disposed of for 160 crore. If the risk-free rate of interest is 8% then what will be value of abandonment option.

Suggested Answer and Working Notes:

Decision Tree showing pay off Year 0 Year 1 Pay off 200 260 0 120 160 - 120 = 40 First of all we shall calculate probability of high demand (P) using risk neutral method as follows: 8% = p x 30% + (1-p) x (-40%) 0.08 = 0.30 p - 0.40 + 0.40p p = 0.48/0.70 = 0.686 The value of abandonment option will be as follows: Expected Payoff at Year 1 = p x 0 + [(1-p) x 40] = 0.686 x 0 + [0.314 x 40] = 12.56 crore Since expected pay off at year 1 is 12.56 crore. Present value of expected pay off will be: 12.56/1.08 = 11.63 crore. This is the value of abandonment option (Put Option).

Topics: Advanced Capital Budgeting Decisions

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