You have the opportunity to buy a project that yields at the end of years 1–5 the following (random) cash flows: End of year 1 cash flow is normal with mean 1,000 and standard deviation 200. For t 1, end of year t cash flow is normal with Mean actual end of year (t 1) cash flow and Standard deviation .2*(mean of year t cash flow). a Assuming cash flows are discounted at 10%, deter- mine the expected NPV (in time 0 dollars) of the cash flows of this project. b Suppose we are given the following option: At the end of year 1, 2, 3, or 4, we may give up our right to fu- ture cash flows. In return for doing this, we receive the abandonment value given in Table 5. Assume that we make the abandonment decision as follows: We abandon if and only if the expected NPV of the cash flows from the remaining years is smaller than the abandonment value. For example, suppose end of year 1 cash flow is $900. At this point in time, our best guess is that cash flows from years 2–5 will also be $900. Thus, we would abandon the project at the end of year 1 if $3,000 exceeded the NPV of receiving $900 for four straight years. Otherwise, we would continue. What is the expected value of the abandonment option? Time Abandoned Value ReceivedEnd of year 1 $3,000End of year 2 $2,600End of year 3 $1,900End of year 4 $900
You have the opportunity to buy a project that yields at the end of years 1–5 the following (random) cash flows: End of year 1 cash flow is normal with mean 1,000 and standard deviation 200. For t 1, end of year t cash flow is normal with Mean actual end of year (t 1) cash flow and Standard deviation .2*(mean of year t cash flow). a Assuming cash flows are discounted at 10%, deter- mine the expected NPV (in time 0 dollars) of the cash flows of this project. b Suppose we are given the following option: At the end of year 1, 2, 3, or 4, we may give up our right to fu- ture cash flows. In return for doing this, we receive the abandonment value given in Table 5. Assume that we make the abandonment decision as follows: We abandon if and only if the expected NPV of the cash flows from the remaining years is smaller than the abandonment value. For example, suppose end of year 1 cash flow is $900. At this point in time, our best guess is that cash flows from years 2–5 will also be $900. Thus, we would abandon the project at the end of year 1 if $3,000 exceeded the NPV of receiving $900 for four straight years. Otherwise, we would continue. What is the expected value of the abandonment option?
Time Abandoned Value Received
End of year 1 $3,000
End of year 2 $2,600
End of year 3 $1,900
End of year 4 $900
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