US CMA Part 2 · Chapter 8 · Question 14 of 15
A mining company's project has a slightly negative NPV based on expected cash flows, but the company can abandon the project and sell the equipment if commodity prices fall. How does this flexibility affect the evaluation?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: A) The abandonment option has value, which should be added to the static NPV and may make the project acceptable
Explanation
Real options, such as the option to abandon, expand, delay or switch, give management flexibility to respond to new information. An abandonment option limits downside losses, so it has positive value. The strategic (expanded) NPV equals static NPV plus the value of the real options and can turn a marginally negative project into an acceptable one.
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