A project can be abandoned at the end of 1 year; the proceeds would be $100,000. If the project continues, the present value (at t = 0) of the future proceeds past year 1 would equal $160,000. The risk-free rate is 0.10, and the volatility (standard deviation) of the project's cash flows, assuming no abandonment, is 1.30.
1. What is the value of the option to abandon?
2. If everything stays the same as in (a) except the standard deviation drops to 0.20, what is the value of the option to abandon? Why does this occur?