AN ASSIGNMENT ON RISK AND MANAGERIAL OPTIONS IN CAPITAL BUDGETING (THE OPTION TO ABANDONMENT)

Course Code: FIN-405 Course Title: Corporate Finance Submitted To: Md. Ridwan Reza Senior Lecturer Dept. Of Business Administration

Submitted By: Name Ephraim Sangma Shaker Ahmed Shariar Hussain Chy Md. Abul Kashem Chy Id 0903010004 0903010021 0903010034 0903010040

Dept. Of Business Administration Leading University, Sylhet. Date of Submission : 2nd January, 2013.

THE OPTION TO ABANDON When investing in new projects, firms worry about the risk that the investment will not pay off and that actual cash flows will not measure up to expectations. Having the option to abandon a project that does not pay off can be valuable, especially on projects with a significant potential for losses. This may consist of selling the projects assets or employing them in another area of the enterprise. In either case, an abandonment value can be estimated. Certain projects, however, have no external market value or alternative use, and for them abandonment value is zero. In general, an investment project should be abandoned when 1. Its abandonment value exceeds the present value of the projects subsequent future cash flows. 2. It is better to abandon the project at that time then it is to abandon it at some future date. When the ability to abandon exists, the worth of an investment project may be enhanced. Thus we can say that Project worth = NPV without abandonment + Value of abandonment option The recognition of an abandonment option may have a significant effort on project selection.

EXAMPLE OF THE OPTION TO ABANDON Firm can buy $300 worth of machinery which will generate cashflows over the next two years. The discount rate used to evaluate this investment is 12%. The possible cashflows are:

Year 1 Cashflow 200

Probability 0.3

Year 2 Cashflow 100 200 300 200 300 400 300 400 500

Probability 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.4 0.3

300

0.4

400

0.3

Note: What happens in year 2 depends on what happens in year 1. If the year 1 cashflow is high, the year 2 cashflow tends to be high (and vice versa). In other words, if the project seems to be doing well in the first year it tends to keep on doing well, but if it does badly it tends to keep on doing badly. WHAT IS THE EXPECTED NPV? There are nine different possible outcomes for the cashflows in the two years. You can figure out the present value of the cashflows in each case, and the probability of those cashflows occurring. Use these to get the E[PV]. Subtracting the $300 initial investment gives the E[NPV]. Cashflows (200,100) (200,200) (200,300) (300,200) (300,300) (300,400) (400,300) (400,400) (400,500) Present Value 259 338 418 427 507 587 596 676 756 Probability (0.3)(0.3)=0.09 (0.3)(0.5)=0.15 (0.3)(0.2)=0.06 (0.4)(0.3)=0.12 (0.4)(0.5)=0.20 (0.4)(0.2)=0.08 (0.3)(0.3)=0.09 (0.3)(0.4)=0.12 (0.3)(0.3)=0.09 E[PV]= E[NPV]= PV times Prob. 23 51 25 51 101 47 54 81 68 $501 $201

Therefore, the expected NPV is $201. This is the NPV without the possibility of abandonment. Now, assume that there is an option involved. After the first year you can abandon the project and sell it off for $250. What is the NPV of the project including the value of the abandonment option?

There are three cases to examine, depending on what the first years cashflow turns out to be. i) First years cashflow is $200. Expected Cashflow in year 2 = 100(0.3)+200(0.5)+300(0.2) =$190 E[PV] as of year 1 = 190/1.12 = $169.64 Therefore, you will abandon the project after the first year because you can get more ($250) abandoning than you expect to get if you keep the project running. Thus, the NPV of the project in this case will be: 200 + 250 NPV = 300 + 112 . = $101.79 ii) First years cashflow is $300. Expected Cashflow in year 2 = 200(0.3)+300(0.5)+400(0.2) =$290 E[PV] as of year 1 = 290/1.12 =$258.93 Therefore, if the first cashflow turns out to be $300 you will keep the project going. Thus, the NPV of the project in this case will be: 300 290 NPV = 300 + + 112 (112) 2 . . = $199.04

iii) First years cash flow is $400. Expected Cashflow in year 2 = 300(0.3)+400(0.4)+500(0.3) = $400

Therefore, if the first cashflow turns out to be $400, you will keep the project going. The NPV of the project in this case is: NPV = 300 + 400 400 + 112 (112) 2 . . = $376.02

There are three possible outcomes and we know the probability of each. The expected NPV of the project is therefore: E[NPV] = (0.3)(101.79) + (0.4)(199.04) + (0.3)(376.02) = $222.96 Note that this is greater than the E[NPV] without the option to abandon. The value of the option to abandon is 222.96 201 = $21.96

CONCLUSION The option to abandon refers to the right that firms often possess to walk away from poor investments. To the extent that this reduces the firms exposure to the worst outcomes, it can make the difference between investing in a new project and not.