Answer:
$131,283
Explanation:
Upstate Price = Present Value of Cash Flows if Demand is High / Value of Project = $14.3 million / $12.9 million = 1.10853
Downstate Price = Present Value of Cash Flows if Demand is Low / Value of Project = $8 million / $12.9 million = 0.62016
<em>Now, the computation of Probability of Demand being High</em>
Risk Free Rate = (Probability of Rise) * (U-1) + (1 - Probability of Rise) * (d-1)
0.06 = (Probability of Rise) * (1.10853 - 1) + (1 - Probability of Rise) * (0.62016 - 1)
0.06 = (Probability of Rise) * 0.10853 + (1 - Probability of Rise)*(-0.37984)
0.06 = 0.10853 Probability of Rise + 0.37984 Probability of Rise - 0.37984
0.06 + 0.37984 = 0.10853 Probability of Rise + 0.37984 Probability of Rise
0.43984 = 0.10853 + 0.37984 Probability of Rise
0.43984 = 0.48837 Probability of Rise
Probability of Rise = 0.43984 / 0.48837
Probability of Rise = 0.9006286217417122
Probability of Rise = 0.9006
Probability of Fall = 1 - 0.9006
Probability of Fall = 0.0994
Value of the option to abandon = Probability of Fall * (Selling Price - Cash Flow if Demand is Low)/(1 + Risk Free rate)
Value of the option to abandon = 0.0994 * ($9,400,000-$8,000,000) / (1 + 0.06)
Value of the option to abandon = 0.0994 * $1,400,000/1.06
Value of the option to abandon = $139,160 / 1.06
Value of the option to abandon = $131283.0188679245
Value of the option to abandon = $131,283
