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…

CA Final · Advanced Financial Management · MTP · January 2026
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 the project after one year by selling it to a competitor for 100 crore if the market conditions are unfavorable and the demand is low, the project's value will decline by 60%. However, if the market conditions turn out to be favorable and the demand for cement is high, the value of the project at the end of year 1 will increase by 50%. Given that the risk free rate of interest as 8%, what will be the value of the abandonment option?

Suggested Answer and Working Notes:

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.

Topics: Advanced Capital Budgeting Decisions

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