Principles of Corporate Finance_ 12th Edition

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Chapter 10 Project Analysis 265


bre44380_ch10_249-278.indd 265 10/08/15 09:51 AM


advantage of the flexibility provided by technology B if you are unsure whether the new
outboard will sink or swim in the marketplace. If you adopt technology B and the outboard is
not a success, you are better off collecting the first year’s cash flow of $1.5 million and then
selling the plant and equipment for $17 million.


Figure  10.6 summarizes Example 10.1 as a decision tree. The abandonment option occurs
at the right-hand boxes for technology B. The decisions are obvious: continue if demand is
buoyant, abandon otherwise. Thus the payoffs to technology B are


Buoyant demand → continue production → payoff of $22.5 million
Sluggish demand → exercise option to sell assets → payoff of 1.5 + 17 = $18.5 million

Technology B provides an insurance policy: If the outboard’s sales are disappointing, you
can abandon the project and receive $18.5 million. The total value of the project with technol-
ogy B is its DCF value, assuming that the company does not abandon, plus the value of the
option to sell the assets for $17 million. When you value this abandonment option, you are
placing a value on flexibility.


Production Options


When companies undertake new investments, they generally think about the possibility that at
a later stage they may wish to modify the project. After all, today everybody may be demanding


● ● ● ● ●

◗ FIGURE 10.6
Decision tree for the Wankel
outboard motor project.
Technology B allows the
firm to abandon the project
and recover $18.5 million if
demand is sluggish.
Technology A

Demand
revealed

Demand
revealed

Technology B

Buoyant

Sluggish

$24 million

$16 million

$22.5 million

$20 million

$15 million

$18.5 million

Abandon

Continue

Continue

Abandon

Buoyant

Sluggish
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