WEB EXTENSION
25A
The Abandonment Real
Option
This extension illustrates the valuation of abandonment options.
25.1 T
HE
A
BANDONMENT
O
PTION
:A
N
I
LLUSTRATION
Synapse Systems produces a variety of switching devices for computer networks at
large corporations. It is considering a proposal to develop and produce a wireless net
work targeted at homes and small businesses. The required manufacturing facility
will cost $26 million. Synapse can accurately predict the manufacturing costs, but
the sales price is uncertain. There is a 25% probability that demand will be strong
and Synapse can charge a high price; see Table 25A1 for detailed projections of
operating cash flows over the 4year life of the project. There is a 50% chance of
moderate demand and average prices as well as a 25% chance of weak demand and
low prices. The cost of capital for this project is 12%.
Synapse can sell the equipment used in the manufacturing process for $14 million
after taxes at Year 1 if customer acceptance is low. In other words, Synapse can aban
don the project at Year 1 and avoid the negative cash flows in subsequent years.
This abandonment option resembles a put option on stock. It gives Synapse the
opportunity to sell the project at a fixed price of $14 million at Year 1 if the cash
flows beyond Year 1 are worth less than $14 million. If the cash flows beyond Year
1 are worth more than $14 million, then Synapse will let the put option expire and
keep the project.
Approach 1. DCF Analysis Ignoring the Abandonment
Option
Using the expected cash flows from Table 25A1 and ignoring the abandonment
option, the traditional NPV is

$1.74 million:
NPV
¼

$26
þ
$6
:
00
ð
1
þ
0
:
12
Þ
1
þ
$7
:
50
ð
1
þ
0
:
12
Þ
2
þ
$9
:
00
ð
1
þ
0
:
12
Þ
3
þ
$10
:
25
ð
1
þ
0
:
12
Þ
4
¼

$1
:
74
:
Based only on this DCF analysis, Synapse should reject the project.
Approach 2. DCF Analysis with a Qualitative
Consideration of the Abandonment Option
The DCF analysis ignores the potentially valuable abandonment option. Qualita
tively, we would expect the abandonment option to be valuable because the project
1
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View Full Documentis quite risky, and risk increases the value of an option. The option has 1 year until it
expires, which is relatively long for an option. Again, this suggests that the option
might be valuable.
Approach 3. DecisionTree Analysis of the
Abandonment Option
Part 1 of Figure 25A1 shows a scenario analysis for this project. There is a 25%
chance that customers will accept a high price for the product, with the cash flows
shown in the top line. There is a 50% chance that Synapse can charge a moderately
high price; the cash flows of this scenario are in the middle row. However, if custo
mers are reluctant to buy the product then Synapse will have to cut prices, resulting
in the negative cash flows shown in the bottom row. The sum in the last column in
Part 1 shows the expected NPV of

$1.74 million, which is the same value as calcu
late using traditional DCF analysis.
Part 2 of Figure 25A1 shows a decisiontree analysis in which Synapse abandons
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 Spring '10
 MR.Wroshr
 Net Present Value, Probability theory, Strike price

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