The expected present value of cash flow is $100,920,000. Given the
cost of the building of $90,000,000, the expected net present value of the
new building is $10,920,000. The expected net present value exceeds zero
and the new building can be justified at a cost of capital of 10 percent. The
expected internal rates of return (IRRs) of the project for the 64 scenarios
are shown in Table 4.4.
The expected IRR for the project is 11.14 percent. The expected IRR
exceeds the cost of capital, and hence the expected net present value is pos-
itive. The expected variance of the project is 16.3 percent, and the calcula-
tions are shown in Table 4.5.
What is the economic benefit of being able to abandon the new build-
ing project after year 2 at an abandonment value of $70,000,000? If the
abandonment value of $70 million exceeded the expected present value of
Real Options and the Investment Decision 57
TABLE 4.4 Calculation of Expected Internal Rate of Return
State of Cash Flow
Economy Year 1 Year 2 Year 3 IRR Prob1 Prob2 Prob3 JointProb E IRR
Depression 10 5 1 –0.645 0.10 0.15 0.20 0.00300 –0.0019
10 5 25 –0.278 0.10 0.15 0.50 0.00750 –0.0021
10 5 30 –0.239 0.10 0.15 0.25 0.00375 –0.0009
10 5 40 –0.173 0.10 0.15 0.05 0.00075 –0.0001
10 10 1 –0.570 0.10 0.35 0.20 0.00700 –0.0040
10 10 25 –0.249 0.10 0.35 0.50 0.01750 –0.0044
10 10 30 –0.212 0.10 0.35 0.25 0.00875 –0.0019
10 10 40 –0.147 0.10 0.35 0.05 0.00175 –0.0003
10 20 1 –0.449 0.10 0.40 0.20 0.00800 –0.0036
10 20 25 –0.190 0.10 0.40 0.50 0.02000 –0.0038
10 20 30 –0.157 0.10 0.40 0.25 0.01000 –0.0016
10 20 40 –0.097 0.10 0.40 0.05 0.00200 –0.0002
10 30 1 –0.350 0.10 0.10 0.20 0.00200 –0.0007
10 30 25 –0.134 0.10 0.10 0.50 0.00500 –0.0007
10 30 30 –0.103 0.10 0.10 0.25 0.00250 –0.0003
10 30 40 –0.048 0.10 0.10 0.05 0.00050 0.0000
Recession 15 10 3 –0.489 0.30 0.10 0.15 0.00450 –0.0022
15 10 20 –0.267 0.30 0.10 0.45 0.01350 –0.0036
15 10 30 –0.189 0.30 0.10 0.30 0.00900 –0.0017
15 10 40 –0.125 0.30 0.10 0.10 0.00300 –0.0004
15 20 3 –0.385 0.30 0.40 0.15 0.01800 –0.0069
15 20 20 –0.204 0.30 0.40 0.45 0.05400 –0.0110
15 20 30 –0.133 0.30 0.40 0.30 0.03600 –0.0048
15 20 40 –0.074 0.30 0.40 0.10 0.01200 –0.0009
15 50 3 –0.141 0.30 0.35 0.15 0.01575 –0.0022
15 50 20 –0.027 0.30 0.35 0.45 0.04725 –0.0013
15 50 30 0.025 0.30 0.35 0.30 0.03150 0.0008
15 50 40 0.072 0.30 0.35 0.10 0.01050 0.0008
15 60 3 –0.074 0.30 0.15 0.15 0.00675 –0.0005
15 60 20 0.027 0.30 0.15 0.45 0.02025 0.0005
15 60 30 0.075 0.30 0.15 0.30 0.01350 0.0010
15 60 40 0.118 0.30 0.15 0.10 0.00450 0.0005
(Continued)