A firm is considering a 2-year project with an initial outlay of $12,000. The costs of operating in years 1 and 2 are known with certainty to be $30,000. However, the revenues are uncertain. There is a
50% chance that year 1 revenues will be $42,000 and a 50% chance that year 1 revenues will be
$30,000. Second year revenues are also uncertain, but depend to some extent on the state realized
in year 1. If the good state is realized in year 1 (i. e., revenue of $42,000), there will be a 50% chance
of an upturn to $60,000 in year 2, and a 50% chance of a downturn to $36,000 in year 2. Similarly, if
the bad state (i. e., revenue of $30,000) is realized in year 1, there will be a 50% chance of an upturn
to $36,000 in year 2, and a 50% chance of a downturn to $12,000 in year 2.
a. Use DCF analysis to find the expected NPV of this project, ignoring the option to abandon,
assuming a 10% cost of capital.
b. What is the project’s correct NPV, considering the abandonment option, and what then is the
value of the option to abandon?