Hello Cath,
This real option question is driving me bonkers. This type came up in the official Kaplan mock, too, so I really want to know where I am going wrong.
Many many thanks for your help!!!
L is considering investing in a machine that has an expected useful life of 3 years. Annual savings will 10000, 20000 or 30000, each equally likely. The savings in the first year will continue in the 2nd and 3rd years.
Machine costs 35000, no scrap value, 10% return on capital investment.
The vendor offered to take the machine back at the end of year 1 and refund 20000 of the initial investment if it does so. What is the value of this abandonment option?
So, my calculation:
1) NPV without the option: (35000) + (10000*33.3%+20000*33.3%+30000*33.3%)*2.487 (from table n=3 r = 10) = 14740
2) NPV with abandonment option. I assumed here the project will be abandoned only if 10000 saving because all others have a + NPV
a) 33.33% we will have 10000 savings in which case year 1 cash flows are 10000 + 20000 refund
(35000) + (10000+20000)*0.909 (from table n=1 r =10) = (7730)
b) 66.66% we will continue, expected savings for 3 years = 20000*0.5+30000*05 (equally likely) = 25000
(35000) + (25000*2.487) = 27175
NPV of abandonment option = (7730)*33.3% + 27175*66.6% = 15540
Value of abandonment option = 15540-14740 = 800
However the correct answer is: 10800
CIMA Forums
Real Options
Hi,
Thanks for your question.
I have found the scenario discussed on CIMA P2 practice paper but I do believe that valuation of real options is beyond the scope of the P2 syllabus.
According to information issued by CIMA, P2 students need to be able to discuss the consequences of long term projects and this includes an understanding of real options ( to follow on , to delay or to abandon). It does not mention calculation of these which is why the current Kaplan text nor Open Tuition notes cover this method.
I will get confirmation from CIMA as to whether this method is required knowledge for P2 and come back to you.
Many Thanks
Cath
Hello Cath. Did you get any feedback from cima?
My exam is soon and this type of q came up a few times in Kaplan mocks.
Also I am quite curious of the solution even if not in syl
Please accept my apologies for delay - Ive been pondering this question and also got Open Tuition's John Moffat to look at this.
We both agree with you that your calculation is correct - the value of abandonment option is approx 800 ( rounding allowable).
It doesnt happen often but I do believe on this occasion CIMA's answer must be incorrect.
Ill log a call to speak with CIMA connect to ask them to verify - but in the meantime have confidence that your workings and understanding of this topic area are sound.
Good luck for the P2 exam
Thank you very much for your help!!!
I passed and I have no doubt that the Opentuition videos and your kind help was a major part of my success
Well thank you for the kind words - its what we are here for :-)
Good luck with the next subject.
Kind Regards
Cath
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