Problem:
ABC is considering building a drilling for water factory. The equipment will cost $625 today, and in one year it will be known whether or not there is water at the site and, therefore, whether the project a success or failure. Engineering estimates a 60% chance of success. Finance has calculated the PV at t =1 for successful project to be $1,000 and the PV for a failure at t = 1 to be $0. Finance uses a discount rate of 10%.
Q1. Calculate the NPV today using a traditional NPV analysis. Should I reject or accept the project.
Q2. Assume Finance has determined that if the project is a failure, the equipment could be sold for $400 at t=1. When you include this abandonment option, what is the NPV of the project? Should I reject or accept the project.
Q3. Based on your answers to (1) and (2), calculate the value of the option to abandon.