premium paid to acquire the future investment cash flow of the project
resulting from the R&D activities. A pharmaceutical firm that engages
in R&D expenditures may need to consider abandonment values and
decisions. Current R&D projects lead to future and expansive R&D
projects. A current or static negative net present value need not lead
management to eliminate the R&D project from its consideration. It is
possible to reconsider the project at a later date when initial cash outlays
of projects change, costs of capital change, or estimated future cash
flows are different.
Abandonment Value
A project does not always produce its expected cash flow, and the net pres-
ent value of a project, initially calculated to be positive, does not always
produce value for the stockholders. How does management come to grips
with cash flow forecasts that turn out to be incorrect or based on assump-
tions that are not substantiated? What can the firm’s financial managers do
to minimize stockholders’ losses? A possible solution is abandonment of
the project.
Let us develop an investment scenario where abandonment value en-
hances our decision-making process. An R&D project requires the con-
struction of a new building near to, but off, the main corporate grounds.
The new building will cost $90,000,000 and can house a small production
facility for three years even if management decides to forgo or postpone
the R&D project. Sales of the production facility are dependent on the
state of the economy. The corporate economists have prepared a set of
three-year cash flow forecasts that are first-year probabilities and second-
and third-year conditional probabilities. That is, the cash flow forecasts are
dependent on particular states of nature occurring in years 1 and 2. (See
Table 4.2.) One should calculate the expected net present value of the pro-
jected cash flow, assuming a 10 percent cost of capital.
The calculations of the expected net present value and internal rate
of return are shown in Table 4.3. One multiplies the cash flow under the
various economic scenarios—depression, recession, normal, and boom—
by the cash flow occurring in that state of the economy. For the four sce-
narios, three-period analysis produces 64 possible states of the economy.
The key to the analysis is to calculate the joint probabilities of each pos-
sible state. Each state of the economy is conditional upon the previous
period’s state of the economy. See Table 4.3 for the calculation of the
joint probabilities, the expected present value, and the expected net pres-
ent value.