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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 millionTechnology 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 ADemand
revealedDemand
revealedTechnology BBuoyantSluggish$24 million$16 million$22.5 million$20 million$15 million$18.5 millionAbandonContinueContinueAbandonBuoyantSluggish