Solved

Exhibit 14.4 The Z−90 Project Being Considered by Steppingstone Inc. (SI) Has

question 11

Multiple Choice

Exhibit 14.4
The Z−90 project being considered by Steppingstone Inc. (SI) has an up-front cost of $250,000. The project's subsequent cash flows are critically dependent on whether another of its products, Z−45, becomes an industry standard. There is a 50% chance that the Z−45 will become the industry standard, in which case the Z−90's expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the Z−45 will not become the industry standard, in which case the Z−90's expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.

-Refer to Exhibit 14.4.Now assume that one year from now SI will know if the Z−45 has become the industry standard.Also assume that after receiving the cash flows at t = 1,SI has the option to abandon the project,in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1.Assuming that the cost of capital remains at 12%,what is the estimated value of the abandonment option?

Definitions:

Indeterminate

describes a situation or outcome that is not precisely determined, fixed, or established, often due to insufficient information or inherent variability.

Total Utility

The overall pleasure gained from utilizing a certain quantity of goods or services.

Marginal Utility

The change in satisfaction or utility obtained by consuming an additional unit of a good or service.

Beers

Alcoholic beverages made from grain, water, hops, and yeast, typically fermented and varying widely in flavor, strength, and type.