Indian manufacturer TEJ Ltd. has just completed new project. Based on capital budgeting evaluation of the project Present Value is 500 Lakhs without…

CA Final · Advanced Financial Management · PYQS · January 2026
Indian manufacturer TEJ Ltd. has just completed new project. Based on capital budgeting evaluation of the project Present Value is 500 Lakhs without the abandonment option. However, due to geopolitical issues and international trade war the project may be at risk and company may have to discontinue the project. It is estimated that if favourable conditions remain, Present Value of the project shall increase by 20%. Whereas, if international trade war continues due to geopolitical issues the Present Value of proposal shall reduce by 30%. In case company is not interested to continue the project it can be disposed off for 450 Lakhs to avoid future huge losses. The risk-free rate of interest is 8%. Required: Calculate the value of abandonment option using risk neutral method.

Suggested Answer and Working Notes:

Decision Tree showing pay off Year 0 500 Year 1 600 350 Option Pay off 0 450-350 = 100 First of all we shall calculate probability of high demand (p) using risk neutral method as follows: 8% = p x 20% + (1-p) x (-30%) 0.08 = 0.20 p - 0.30 + 0.30p 0.38 = 0.50p p = 0.76 The value of abandonment option will be as follows: Expected Payoff at Year 1 = p x 0 + [(1-p) x 100] = 0.76 x 0 + [0.24 x 100] = 24 Lakhs Since expected pay off at year 1 is 24Lakhs. Present value of expected pay off will be: 24.00 / 1.08 = 22.22 Lakhs This is the value of abandonment option (Put Option).

Topics: Advanced Capital Budgeting Decisions

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