A firm is considering a project with a 6-year life and an initial cost of $67,500. The appropriate discount rate for this project is 13%. The firm expects sales to be $23,000/year for the first 3 years. Beyond year 3, there is a 40% chance that sales will fall to $12,000/year for years 4, 5, and 6 and a 60% chance that sales will rise to $25,000/year for those three years. The project also contains an abandonment option: the firm will have the option to abandon the project after 3 years (i.e., at t=3) by selling it for $40,000 (after taxes). By the time the firm faces the decision whether to continue or abandon at t=3, it will know which state will be realized in years 4 through 6 (should the project be continued).
(a) Calculate the expected net present value of this project in the absence of the abandonment option.
(b) Calculate the value (in today’s dollar terms) of the abandonment option.