A firm is considering a proposal to set up a cement manufacturing plant with an initial investment of 150 crore. The firm has the option to abandon…

Decision Tree showing pay off Year 0 Year 1 Option Pay off 225 0 -150 60 100 - 60 = 40 First of all, we shall calculate probability of high demand (p) using risk neutral method as follows: 8% = p x 50% + (1-p) x (-60%) 0.08 = 0.50 p - 0.60 + 0.60p p = 0.68/1.10 = 0.618 or 0.62 The value of abandonment option will be as follows: Expected Payoff at Year 1 = p x 0 + [(1-p) x 40] = 0.618 x 0 + [0.382 x 40] = 15.28 crore Since expected pay off at year 1 is 15.28 crore. Present value of expected pay off will be: = 15.28 / 1.08 = 14.15 crore Thus, the value of abandonment option is 14.15 crore. Value of Project with abandonment option - (i) If PVF is not considered Expected Value of the Project without abandonment option = (0.618 x 225 crore + 0.382 x 60 crore) – 150crore = 11.97 crore Value of Project with abandonment Option = 11.97 crore +14.15 crore = 26.12 crore Or Expected Value of the Project without abandonment option = (0.62 x 225 crore + 0.38 x 60 crore) – 150 crore = 12.30 crore Value of Project with abandonment Option = 12.30 crore +14.15 crore = 26.45 crore (ii) If PVF is considered Expected Value of the Project without abandonment option = (0.618 x 225 crore + 0.382 x 60 crore)/1.08 – 150 crore = -0.028 crore OR -0.03 Value of Project with abandonment Option = -0.028 crore + 14.15 crore = 14.122 crore OR 14.12 crore Or Expected Value of the Project without abandonment option = (0.62 x 225 crore + 0.38 x 60 crore)/1.08 – 150 crore = 0.28 crore Value of Project with abandonment Option = 0.28 crore + 14.15 crore = 14.43 crore