Question: Acme Mining Company is considering digging a new copper mine. The mining equipment will cost dollar 625 today, and in one year it will be known whether or not there is copper at the site and, therefore, whether the mine is a success of failure. The mining engineers estimate a 60 percent chance of success and the financial staff has computed the PV at t =1 of a successful mine to be dollar 1,000 and the PV of a failure at t = 1 to be $0. The financial staff uses a discount rate of 10 percent.
[A] Compute the NPV today using a traditional NPV analysis. Explain would you accept or reject the project?
[B] Suppose the financial staff has determined that if the project is a failure, the mining equipment could be sold for dollar 400 at t=1. When you include this abandonment option, determine the NPV of the project? Would you accept or reject.
[C] Based on your answers to [A] & [B], Compute the value of the option to abandon.