And do nothing.

Let's see what the NPV of the project would be if

we did not have this abandonment option.

Well, clearly when we sit here, this stage is very risky.

And let's say that for this stage we have the rate of discounting that stays at 25%.

Well, if we do not have this option,

then we can say what if we apply this rate all the way through?

Let's see what the NPV would be.

Then the NPV is minus 250, which happens now.

And then we have the probability, this doesn't exist.

We say, plus probability one-half of the upper path.

And here, what do we have?

We have an investment of here minus 2 million.

Then we have 500 in perpetuity that we have to divide by 0.25.

This is the rate that we'll use all the way through.

This is the present value of perpetuity at 0.1.

All that should be discounted at 1.25 because that occurs at 0.1.

But you don't have to, because you can see that 501

over 0.25 that's exactly 2,000, so

all this is 0 and we end up with NPV of minus 250.

So what is our decision?

Well, this is a negative NPV project,

we don't have to take it.

However, let's say that we arrived at point one and

we have the option to stop here.

And at this point, we no longer have this dichotomy.

We are not playing further with these probabilities.

So if we sit at point one, then the future of

this project is much less uncertain.

And again, this is only for the sake of simplicity.

Let's say that if we sit here, then the right rate is r cap, which is 10%.

Well, the rate of the first period stays at 25, because this risk and

this uncertainty stays.

However, further on, whether it's the upper path or the lower path,

there's clearly the NPV of 0 here, we can use this rate.

Now, let's recalculate this NPV, I will use the blue.

We have the same minus 250, but we also have the same one half,

because we have to arrive at this point.

We have to discount that by 125, one way, but

here we have minus 2,000 plus 500 divided by 0.1.

And this is 5,000, this is 3,000 and

then if you put everything together you have plus 950.

Well that's a huge difference.

Well, you can say, no wonder, because we used much lower rate here.

And therefore the contribution of $500,000 in perpetuity is much more valuable.

But like I said before, if we do not have this ability to

stop here then we cannot use a different rate at this point in time.

So that is sort of, in a very grossly simplified way,

the idea of this abandonment option.

Now, let me proceed with some more fine tuned idea here,

because strictly speaking, even if I stay at point

zero I do not have to engage in this test project.

So we are producing on this list,

the simplified decision tree.

And we start at point zero here, in which we can go down there and do nothing.

So we can stop right away.