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Dear Sir,
I want to ask you to clarify a question on option to abandon.
Question:
A company has developed a new process with the following data:
Conventional NPV $10m
Capital expenditure $90m
10-year life
Volatility of the project’s future cash flows = 45%
Risk-free rate = 5%
The company has the option to abandon the project at any time and sell the technology for an estimated $40m.
Required:
Use the Black-Scholes model to estimate the value of the abandonment option and the total value of the project.In the answer, Pa, the underlying asset value is determined as $100m (i.e. investment $90m + NPV $10). Is this wrong, Sir?
No, it is not wrong.
Pa is the PV of the future flows.
Since the NPV is the PV of the future flows minus the initial investment, it means that the PV of the future flows is equal to the NPV plus the initial investment.
Hi Sir,
I thought Pa = PV of cash flows foregone if the project is abandoned. Could you please clarify it here? Thank you.
Pa is indeed the PV of the cash flows foregone, but again the PV of the future flows is equal to the NPV plus the investment as I explained in my previous reply.
Effectively yes because there are no dates given in the question which is strange.
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