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Question
Now assume that the project has an abandonment option. At the end of each year you can abandon the project for the values given below:
For example, suppose that year 1 cash flow is $400. Then at the end of year 1, you expect cash flow for each remaining year to be $400. This has an NPV of less than $6200, so you should abandon the project and collect $6200 at the end of year 1. Estimate the mean and standard deviation of the project with the abandonment option. How much would you pay for the abandonment option? (Hint: You can abandon a project at most once. Thus in year 5, for example, you abandon only if the sum of future expected NPVs is less than the year 5 abandonment value and the project has not yet been abandoned. Also, once you abandon the project, the actual cash flows for future years will 0. So the future cash flows after abandonment should disappear.)
Answer
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