Merritt Company is considering a new project that has a cost of $1,000,000,and the CFO set up the following simple decision tree to show its three most likely scenarios.Merritt could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so,but to obtain this abandonment option,Merritt would have to make a payment to those parties.How much is the option to abandon worth (in thousands) to Merritt? $$800.0$800.0$800.0$938.1$234.5$520.0$520.0$520.0$259.8$129.9−$200.0−$200.0−200.0−$1,484.5−$371.1\begin{array}{l}\begin{array}{lll}\mathrm{WACC}=11.5 \%& \text { Dollars in Thousands }\\&t=10\\\hline \text { Prob }=25 \% & \\\text { Prob }=50 \% & -\$ 1,000 \\\text { Prob }=25 \%\end{array}\begin{array}{lll} \text { NPV this } &\text { Prob } \times\\t=1 & t=2 & t=3 & \text { State } & \text { NPV } \\\hline \$ 800.0 & \$ 800.0 & \$ 800.0 & \$ 938.1 & \$ 234.5 \\\$ 520.0 & \$ 520.0 & \$ 520.0 & \$ 259.8 & \$ 129.9 \\-\$ 200.0 & -\$ 200.0 & -200.0 & -\$ 1,484.5&-\$ 371.1\end{array}\end{array}$

$\begin{array}{r}\text { Exp }-\$ 6.7 \\\text { NPV }\end{array}$

A) $68.8
B) $72.5
C) $76.3
D) $80.1

Question

Merritt Company is considering a new project that has a cost of $1,000,000,and the CFO set up the following simple decision tree to show its three most likely scenarios.Merritt could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so,but to obtain this abandonment option,Merritt would have to make a payment to those parties.How much is the option to abandon worth (in thousands) to Merritt?

$800.0$800.0$800.0$938.1$234.5$520.0$520.0$520.0$259.8$129.9−$200.0−$200.0−200.0−$1,484.5−$371.1\begin{array}{l}\begin{array}{lll}\mathrm{WACC}=11.5 \%& \text { Dollars in Thousands }\\&t=10\\\hline \text { Prob }=25 \% & \\\text { Prob }=50 \% & -\$ 1,000 \\\text { Prob }=25 \%\end{array}\begin{array}{lll} \text { NPV this } &\text { Prob } \times\\t=1 & t=2 & t=3 & \text { State } & \text { NPV } \\\hline \$ 800.0 & \$ 800.0 & \$ 800.0 & \$ 938.1 & \$ 234.5 \\\$ 520.0 & \$ 520.0 & \$ 520.0 & \$ 259.8 & \$ 129.9 \\-\$ 200.0 & -\$ 200.0 & -200.0 & -\$ 1,484.5&-\$ 371.1\end{array}\end{array}

\begin{array}{r}\text { Exp }-\$ 6.7 \\\text { NPV }\end{array}

A) $68.8
B) $72.5
C) $76.3
D) $80.1

Dasani Stallworth · Accepted Answer

Final Answer : C, Explanation :  The option to abandon is worth the difference between the expected NPV without the option and the cost of the project. Without the option, the expected NPV is -$6.7 thousand. With the option, the project would not proceed in the worst-case scenario (-$371.1 thousand NPV), improving the expected outcome. The value of the option is the difference needed to reach a zero NPV from -$6.7 thousand, which is approximately $76.3 thousand.

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