Acme Co Investment Analysis: Value of Option to Abandon Electric Bicycle Business
Understanding Acme Co's Electric Bicycle Investment Decision
Acme Co has decided to make an investment into the electric bicycle business, requiring a initial investment of $1,500,000. The production will start immediately, with potential cash flows generated based on the demand for their electric bicycles.
Probability of High and Low Demand
If there is high demand for Acme's electric bicycles (with 20% probability), a cash flow of $300,000 will be generated every year in perpetuity. On the other hand, low demand (with 80% probability) will result in generating $50,000 each year for two years initially.
Future Possibilities After Low Demand Period
After two years of low demand, there is a possibility for high or low demand for Acme's electric bicycles. If high demand occurs (with 30% probability), it will generate $300,000 each year perpetually. If low demand continues (with 70% probability), it will generate $50,000 each year perpetually.
Government Offer: Option to Abandon Operations
The government is offering Acme an option to abandon its operations and sell all related assets for $1 million at the end of year 4. By choosing this option, Acme will not receive the cash flows generated from the electric bicycle business in that year.
What is the value of the option for Acme to sell all related assets to the government at the end of year 4? The value of the option for Acme to sell all related assets to the government at the end of year 4 is $191,943. To calculate this, we need to use discounted cash flow analysis to determine the present value of the cash flows associated with the electric bicycle business and the selling price of the assets.