Question

Option to abandon

Option A: Suppose that a firm owns a new patent and wants to invest in a project having a
seven-year life. The initial investment is estimated to be 12 million euros (in year 0). Suppose
further that the only source of uncertainty is the revenues for the first year (year 1) and the
revenues for consequently years (2-7) are estimated using the following evolution path: for
the years 2, 3, and 4 the revenues will be increased by 10% yearly, and then they will decrease
by the same percent for the years 5, 6 and 7. The estimated revenues for the year 1 are equal
to 110 million euros. Therefore, the projected revenues based on this estimate and the
evolution path are the following
Year 1:€110,000,000.00

Year 2:€121,000,000.00

Year 3: €133,100,000.00

Year 4: €146,410,000.00
Year 5:€131,769,000.00
Year 6:€118,592,100.00
Year 7:€106,732,890.00
The variable cost for this project is estimated to be 50% of the revenues and the fixed cost will
be 60 million euros per year.

Option B: For the same project, now suppose that the firm has the option to abandon the
project if unfavorable circumstances occur. In detail, the decision rule is to abandon the
project in case of two consecutive yearly negative cash flows. This rule is applied at the
beginning of the 3rd year (examining the cash flows of years 1 and 2) and henceforward.
To decide which of the two options is more profitable you have to prepare a detailed report
to support your decision, assuming a 3% discount rate.
Standard Method
1.1 (40%): Based on the estimated revenues for the 1st year, set up a spreadsheet to calculate
the net present values (NPVs) for this new project, one for each possible option.
1.2 (10%): Based on the results of 1.1, which option is better for investment? Explain your
decision

Answer 1

To compare the profitability of Option A and Option B, we need to calculate their respective net present values (NPV). Option A involves a fixed investment and projected revenues, while Option B considers the possibility of abandoning the project in unfavorable circumstances.

By discounting the projected revenues and accounting for the probability of positive or negative cash flows, we can compare the NPVs of the two options.

Step-by-step explanation:

To compare the profitability of the two options, we need to calculate the net present value (NPV) for each option. By discounting the projected revenues and accounting for the probability of positive or negative cash flows, we can compare the NPVs of the two options.

For Option A, we can calculate the NPV by discounting the projected revenues for each year at a 3% discount rate and subtracting the initial investment. For Option B, we need to consider the possibility of abandoning the project if there are two consecutive yearly negative cash flows.

We can calculate the NPV for each year, taking into account the probability of positive or negative cash flows, and subtracting the fixed cost from the total NPV. After calculating the NPV for both options, we can compare them to determine which option is more profitable.