A firm is considering a project with a 6-year life and an initial cost of $33,750. The appropriate discount rate for this project is 13%. The firm expects sales to be $11,500/year for the first 3 years. Beyond year 3, there is a 40% chance that sales will fall to $6,000/year for years 4, 5, and 6 and a 60% chance that sales will rise to $12,500/year for those three years. The project also contains an abandonment option: the firm will have the option to abandon the project after 3 years (i. e., at t=3) by selling it for $20,000 (after taxes). By the time the firm faces the decision whether to continue or abandon at t=3, it will know which state will be realized in years 4 through 6 (should the project be continued).
Required:
(a) Calculate the expected net present value of this project in the absence of the abandonment option.
(b) Calculate the value (in todayâs dollar terms) of the abandonment option.