Joint Probabilities

Decision Tree Analysis

Certainty Equivalent Method
Risk Adjusted Discount Rate Method

Dr H N Shivaprasad

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 Decision Tree Analysis
• Definition: The Decision Tree Analysis is a schematic representation
of several decisions followed by different chances of the occurrence.
• Simply, a tree-shaped graphical representation of decisions related
to the investments and the chance points that help to investigate the
possible outcomes is called as a decision tree analysis.
• The decision tree shows Decision Points, represented by squares,
are the alternative actions along with the investment outlays, that
can be undertaken for the experimentation.
• These decisions are followed by the chance points, represented by
circles, are the uncertain points, where the outcomes are dependent
on the chance process. Thus, the probability of occurrence is
assigned to each chance point.

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 Decision Tree Analysis

 Decision tree analysis is a tool for analysing situations where sequential

decision making in face of risk is involved.

 The key steps in decision tree analysis are:

1. Identifying the problem and alternatives

2. Delineating the decision tree

3. Specifying probabilities and monetary outcomes

4. Evaluating various decision alternatives

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 Decision Tree

The decision tree, exhibiting the anatomy of the decision situation, shows :

 The decision points (also called decision forks) and the alternative options
available for experimentation and action at these decision points.

 The chance points (also called chance forks) where outcomes are dependent
on a chance process and the likely outcomes at these points.

The decision tree reflects in a diagrammatic form the nature of the decision
situation in terms of alternative courses of action and chance outcomes which have
been identified in the first step of the analysis.

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 Specification of Probabilities and Monetary Value
of Outcomes

Once the decision tree is delineated, the following data have to be gathered :

 Probabilities associated with each of the possible outcomes at various chance

forks, and

 Monetary value of each combination of decision alternative and chance

outcome.

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 Evaluation of Alternatives

Once the decision tree is delineated and data about probabilities and monetary values
gathered, decision alternatives may be evaluated as follows :
1. Start at the right-hand end of the tree and calculate the expected monetary value at
various chance points that come first as we proceed leftward.
2. Given the expected monetary values of chance points in step 1, evaluate the
alternatives at the final stage decision points in terms of their expected monetary
values.
3. At each of the final stage decision points, select the alternative which has the highest
expected monetary value and truncate the other alternatives. Each decision point is
assigned a value equal to the expected monetary value of the alternative selected at
that decision point.

4. Proceed backward (leftward) in the same manner, calculating the expected monetary
value at chance points, selecting the decision alternative which has the highest
expected monetary value at various decision points, truncating inferior decision
alternatives, and assigning values to decision points, till the first decision point is
reached.
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There are two stages in preparing a decision tree. The first step is drawing the decision
tree itself, in a manner that reflects all the choices and outcomes. The second step is to
incorporate probabilities, relevant values and derive expected monetary values.
Rules for drawing a decision tree diagram
Some basic rules in drawing the decision tree are:
Rule 1: A decision tree begins with a decision point. A decision point (also known as
decision node) is represented by a rectangle. An outcome point (also known as chance
node) is denoted by a circle.
Rule 2: Decision alternatives (e.g., sales volume in the preceding example) are shown
by a straight line originating from the decision node.
Rule 3: A decision tree diagram is drawn from left to right. The rectangles and the
circles are sequentially numbered.
Rule 4: Values and probabilities for each branch are then incorporated.
Definition
A decision tree is a graphic device that shows a sequence of strategic decisions and
expected consequences under each possible set of circumstances.
Know it
1. Draw from left to right but evaluate from right to left.
2. Sum up probable values at chance node; pick the best in decision node.

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 Vigyanik case

The scientists at Vigyanik have come up with an electric moped. The

firm is ready for pilot production and test marketing. This will cost Rs.20
million and take six months. Management believes that there is a 70
percent chance that the pilot production and test marketing will be
successful. In case of success, Vigyanik can build a plant costing Rs.150
million. The plant will generate an annual cash inflow of Rs.30 million
for 20 years if the demand is high or an annual cash inflow of Rs.20
million if the demand is moderate. High demand has a probability of 0.6;
Moderate demand has a probability of 0.4. To analyse such situations
where sequential decision making is involved decision tree analysis is
helpful.

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 Vigyanik Case

C21 : High
demand Annual
cash flow
Probability 30 million
: 0.6
D21:Invest
c2
-Rs 150
million C22 : Moderate Annual
C11 : Success demand cash flow
D2 Probability
Probability 20 million
D11: Carry out pilot : 0.4
production and : 0.7 D22: Stop
market test
c1
-Rs 20
million
C12 : Failure D31: Stop
D1 D3
Probability : 0.3

D12:Do nothing

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 Vigyanik Case
The alternatives in the decision tree shown are evaluated as follows:
1. Start at the right-hand end of the tree and calculate the EMV at chance point C2 that comes
first as we proceed leftward.
EMV(C2) = 0.6 [30xPVIFA (20, 12%)] + 0.4 [20 x PVIFA (20, 12%)]
= Rs.194.2 million
2. Evaluate the EMV of the decision alternatives at D2 the last stage decision point.
Alternative EMV
D21 (Invest Rs.150 million) Rs.44.2 million
D22 (Stop) 0
3. Select D21 and truncate D22 as EMV(D21) > EMV(D22).
4. Calculate the EMV at chance point C1 that comes next as we roll backwards.
EMV (C1) = 0.7 [44.2] + 0.3 [0] = Rs.30.9 million
5. Evaluate the EMV of the decision alternatives at D1 the first stage decision point :
Alternative EMV
D11 (Carry out pilot production and
market test at a cost of Rs.20 million) Rs.10.9 million
D12 (Do nothing) 0
Based on the above evaluation, we find that the optimal decision strategy is as follows : Choose
D11 (carry out pilot production and market test) at the decision point D1 and wait for the outcome at
the chance point C1. If the outcome at C1 is C11 (success), invest Rs.150 million; if the outcome at
C1 is C12 (failure) stop.
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 Hashtag Girls – Case Study
A garment manufacturing firm exports high fashion ladies garments to leading
stores in USA, UK and most parts of Europe. However, the promoter wishes to
expand its base in India too. Riding on the boom of e-commerce market, he
wishes to launch his own portal ‘Hashtag Girls’ and sell similar high fashion
ladies garments in India. The cost for this venture is estimated to be
₹30,00,000 which include the designing the website, preparing the entire
range of garments etc.
Looking at the industry estimates , there is 80 % probability that the venture
will be successful. In case of success of this portal, the promoter would get a
big boost and has plans to open in most reputed malls initially in Mumbai and
Delhi. The cost of the project for opening offline stores is ₹2 crores.
The stores are expected to generate a revenue of ₹80 lakhs per annum for the
next five years if the demand is good and an annual revenue of ₹ 50 lakhs per
annum for the next five years if the demand is low. The probability of high
demand is 0.7 and that of low demand is 0.3. Make a decision tree and
evaluate the business proposition.
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 Hash Tag Girls Case

C21 : High Annual

demand cash flow

D21:Invest in Probability 80 Lakhs

: 0.7 for 5 years
Offline Store
- 2 Crores
c2

C22 : Low Annual

C11 : Success demand cash flow
D11: Launch of D2 Probability 50 Lakhs
“Hash Tag Girls Probability for 5 years
: 0.3
Portal : 0.8 D22: Stop
-50 Lakhs c1

C12 : Failure D31: Stop

D1 D3
Probability : 0.2
D12: Continue with
existing operation

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Case Study
ABC Ltd. has incurred an expenditure of Rs. 300 for certain research
findings for developing a new product. They can sell these findings to a
third party for Rs. 150/-. Alternatively, they can take up test runs for
production. The test can lead to positive or negative results, with equal
probability. If the test is positive, they have two choices. Either to sell
the findings to a third party at Rs. 150 or to take up marketing. If
marketing is taken up, the demand can be high, medium, or low. And
the cash flow after tax in these three scenarios will be Rs. 3,000, Rs.
600 or a loss of Rs. 600 respectively. The chances of demand being
high is rated at 30%, while for medium and low demand, the chances
are 40% and 30% respectively. If the test proves negative, they will be
incurring a loss of Rs. 1,800. And still they could sell the findings for
Rs. 150O/-. Depict the decision alternatives in a decision tree diagram,
and decide the action that the company can take.

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 Evaluation
At E: Event (chance) node: EMV computation is as under
Demand Amount Probability Result
level (Rs.) (Rs.)
High 3,000 0.3 900
Medium 600 0.4 240
Low (600) 0.3 (180)

960

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At B: EV is computed as under

Outcome of test EV at C or Probability Result

D
Positive 960 0.5 480
Negative 150 0.5 75

Result 555

At C: The choice is between an EMV of Rs.960, and a value of Rs.150. The

choice would be Rs.960, and EMV at C is Rs.960.
At D: The choice is between value of -1,800 and the value of Rs.150. The
choice would be the value of Rs.150 and hence EV at D is Rs.150.
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EV at B, therefore, is Rs.555.
At A: Choice is between EV of Rs.555 (minus cost
of Rs.300) and a value of Rs.150 (less cost of
Rs.300). The choice will be EV of Rs.555 less cost
of Rs.300. EMV at A is therefore Rs.255. (In fact,
the initial expenditure of Rs.300 is a sunk cost, and
is not relevant for this decision).
Decision: EMV is Rs.255. The action, that the test
may be undertaken, is recommended.

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 Airways Limited Case
Airways Limited has been set up to run an air taxi service in western India. The company is
debating whether it should buy a turboprop aircraft or a piston engine aircraft. The turboprop
aircraft costs 3500 and has a larger capacity. It will serve if the demand turns out to be high.
The piston engine aircraft costs 1800 and has a smaller capacity. It will serve if the demand
is low, but it will not suffice if the demand is high.
The company believes that the chances of demand being high and low in year 1 are 0.6
and 0.4. If the demand is high in year 1, there is an 80 percent chance that it will be high in
subsequent years (year 2 onward) and a 20 percent chance that it will be low in subsequent
years.
The technical director of Airways Limited thinks that if the company buys a piston
engine aircraft now and the demand turns out to be high the company can buy a second-hand
piston engine aircraft for 1400 at the end of year 1. This would double its capacity and
enable it to cope reasonably well with high demand from year 2 onwards.
The payoffs associated with high and low demand for various decision alternatives are
shown in Exhibit 1.1.The payoffs shown for year 1 are the payoffs occurring at the end of
year 1 and the payoffs shown for year 2 are the payoffs for year 2 and the subsequent years,
evaluated as of year 2, using a discount rate of 12 percent which is the weighted average cost
of capital for Airways Limited.
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Exhibit 1.1 Decision Tree Year 1
Year 2
High demand
(0.8) 7000
High demand (0.6)
C Low demand
1000 (0.2)
2
1000

C
High demand
Turboprop 1
(0.4)
- 4000
7000
Low demand (0.4)
C Low demand
200 (0.6)
3
600
High demand
(0.8)
6000
Low demand
D1 C
(0.2)
High demand Expand 5
- 1400 600
(0.6)
D2 High demand
500 (0.8)
Do not
expand 2500
Piston engine
C Low demand
- 1800 (0.2)
6
800
C High demand
4 (0.2)
2500
Low demand (0.4)
C Low demand
300 (0.8)
7 800

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 Airways Limited Solution
If Airways Limited buys the turboprop aircraft, there are no further decisions to be made. So, the NPV of the
turboprop aircraft can be calculated by simply discounting the expected cash flows:
0.6 (1000) + 0.4 (200)
NPV = - 4000 +
(1.12)
0.6 [ 0.8 (7000) + 0.2 (1000) ] + 0.4 [ 0.4 (7000) + 0.6 (600) ]
+ = 389
(1.12) 2

If Airways Limited buys the piston engine aircraft and the demand in year 1 turns out to be high, a further
decision has to be made with respect to capacity expansion. To evaluate the piston engine aircraft, proceed as
follows:
First, calculate the NPV of the two options viz., ‘expand’ and ‘do no expand’ at decision point D2:
0.8(6000) + 0.2 (600)
Expand: NPV = - 1400 = 2993
1.12
0.8 (2500) + 0.2 (800)
Do not expand: NPV = = 1929
1.12
Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option. This means that the NPV at
decision point D2 will be 2923.
Third, calculate the NPV of the piston engine aircraft option.
0.6 (500 + 2923) + 0.4 (300) 0.4 [0.2 (2500) + 0.8 (800)]
NPV = - 1800 + + = 505
(1.12) (1.12)2
Since the NPV of the piston engine aircraft (505) is greater than the NPV of the turboprop aircraft (389), the
former is a better bet. So the recommended strategy for Airways Limited is to invest in the piston engine
aircraft at decision point D1 and, if the demand in year 1 turns out to be high, expand capacity by buying another
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piston engine aircraft: 20
Value of the Option Note that if Airways Limited does not have the option of expanding capacity at
the end of year 1, the NPV of the piston engine aircraft option would be:
0.6 (500) + 0.4 (300)
NPV = - 1800 +
(1.12)
0.6 [0.8 (2500) + 0.2 (800)] + 0.4 [0.2 (2500) + 0.8 (800)]
+ = 28
(1.12)2
Thus, the option to expand has a value of: 505 – 39 = 466.
Option to Abandon So far we assumed that Airways Limited will continue operations irrespective
of the state of demand. Let us now introduce the possibility of abandoning the operation and
disposing off the aircraft at the end of year 1, should it be profitable to do so. Suppose after 1 year
of use the turboprop aircraft can be sold for 3600 and the piston-engine aircraft for 1400.

If the demand in year 1 turns out to be low, the payoffs for ‘continuation’ and ‘abandonment’ as
of year 1 are as follows.
Turboprop Aircraft Piston Engine Aircraft
Continuation : 0.4 (7000) + 0.6(600) Continuation : 0.2(2500) + 0.8 (800)
= 3160/(1.12) =2821 = 1140/(1.12) = 1018
Abandonment : 3600 Abandonment : 1400

Thus in both the cases it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.

The revised decision tree, taking into account the abandonment options, is shown in Exhibit 1.2.
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Exhibit 1.2 Decision Tree Year 1 Year 2

High demand
(0.8)
7000
High demand (0.6)
Low demand
1000
(0.2)
1000
C
Turboprop 1

- 4000 Low demand (0.4)

Sell Turboprop for
200 3600

High demand
D1 (0.8)
6000

High Low demand

Expand
demand - 1400 (0.2)
600
(0.6)
High demand
500 Do not (0.8)
expand 2500

Piston engine
Low demand
- 1800 (0.2)
800

Low demand (0.4)

Sell Piston engine
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Given the decision tree with abandonment possibilities, let us calculate the NPV of the
turboprop aircraft and the piston engine aircraft.

0.6 [1000 + {0.8(7000) + 0.2 (1000)}/(1.12)] + 0.4 (200 + 3600)

NPV (Turboprop) = -4000 +
(1.12)
= 667

0.6 (500 + 2993) + 0.4 (300 + 1400)

NPV (Piston engine) = -1800 + = 678
(1.12)
Note that the possibility of abandonment increases the NPV of the Turboprop aircraft
from 389 to 667. This means that the value of the option to abandon is:

Value of abandonment option = NPV with abandonment - NPV without abandonment

= 667 - 389 = 278

For the piston engine aircraft the possibility of abandonment increases the NPV from 505
to 678. Hence the value of the abandonment option is 173.

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Business is about taking risk and earning return. If you take more risk,
you would like to earn more return. Hence projects with higher risk
should earn higher return.
Higher the risk in a project, higher would have to be the adjustment in
cut off rate and vice versa
Meaning of RADR
The discount-rate in capital budgeting represents the expected rate of
return. Projects with higher risk are generally expected to provide a
higher return. And projects with relatively lower risk are expected to
provide a lower rate of return.
Consequently all projects should not be discounted at the same rate,
namely the company's cost of capital.
Hence the cut-off discount rate should be adjusted upwards or downward
to take care of the additional (or lower) risk element. This is referred to
as risk adjusted discount rate.

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A project will be accepted if it yields a positive NPV using the risk adjusted discount rate.
Remember, two projects with identical standard deviation can fall under two different
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Risk grades.
 It is customary for companies to formulate a schedule of risk categories ranging
from normal (cut off) discount rate to say 10 to 15 percentage points over cut
off rate. The initial cut off rate equals the cost of capital of the entity. As the
risk grade increases, the cut-off rate too goes up. Such a schedule helps the
executives decide the discount rate to be used depending upon the risk of the
project. The following is one such table.
Limitations of RADR
RADR is simple to understand. But its computation is subjective and involves
practical difficulties such as:
•Translating the risk element into percentage terms on a consistent basis.
•Allocation of projects into risk classes.
Not all investors are risk averse. Some may even be willing to pay a premium
to assume risk. In such cases, there will be no adjustment at all, in the cut off
rate!
Risk Category Risk range Discount rate
Category (Indicative) (Indicative)
A Normal 0-10 8%
B Normal plus 11-15 10%
C Medium 16-20 12%
D High 21-25 15%
E Very high 25 20%
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 r k = i+ n + d k
r k = Risk Adjusted Discount Rate
i = risk free rate
n = adjustment for normal risk
d k = adjustment for differential risk

Investment Category Risk Adjusted Discount Rate

Replacement Investments Cost of Capital

Expansion Investments Cost of Capital +3%

Investment in related Cost of Capital + 5%

Investments
Investments in new lines Cost of Capital + 8%

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Certainty Equivalent Coefficients (α) transform expected values of uncertain
flows into their certainty equivalents
Under CE method , the decision maker specifies the sum he must be assured of
receiving , to make him indifferent between a ‘certain sum’ and the expected
value of a ‘risky sum’

CEC (α) =CCF / UCF

CCF = CERTAIN CF
UCF = UNCERTAIN CF

Certainty Equivalent Coefficient

Year 1 Year 2 Year 3 Year 4
Replacement Investments 0.92 0.87 0.84 0.80
Expansion Investments 0.89 0.85 0.80 0.75
New Product Investments 0.85 0.80 0.74 0.68

Research and Development 0.75 0.70 0.64 0.58

Investments
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 CONCEPT PROBLEM
BLUE Prints Ltd, , whose cost of capital is 10% is
considering a project with the following expected cash
flows. The risk free rate is 8%. The NPV at 10% is found to
be positive .
Year 0 1 2 3
Cash Flows (₹) (22500) 17500 12500 12500

• Due to uncertainties about future cash flows, the

management decides to adjust these cash flows to
certainty equivalents , by taking only 65%, 55% and 50%
of the cash flows for the years 1 to 3 respectively. Assess
the viability of the project

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 Step 1: Compute Certain Cash flows
Year Cash Flow (₹) Certainty Factor Certain Cash Flows (₹)
0 (22500) 1.00 (22,500)
1 17,500 0.60 10,500
2 12,500 0.55 6,875
3 12,500 0.50 6,250

Step 2: Compute NPV by discounting at risk free rate of 8%

Year Certain Cash Flows (₹) Discount Factor @ 8% PV of Cash Flows (₹)
0 (22,500) 1.000 (22500)
1 10,500 0.926 9723
2 6,875 0.857 5892
3 6,250 0.794 4963
NPV (1922)

Step 3: Decision – Since NPV is negative the project should be Rejected

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 RADR and CEM
• Under the RADR approach, we adjust the discount
rate with higher risk. That is we use a higher discout
rate. Under CEF Method, we make a downward
adjustment of project cash flows and use the risk-
free rate to arrive at NPV
Factor CEF RADR
What is adjusted Cash Flows Discount Rate
Discount Rate Risk Free Rate Risky Rate

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Step 4: Compute Expected NPV
The expected NPV is the sum of the Expected Outcome and is Rs.6,224 positive.
Hence the project should be ACCEPTED

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Sensitivity analysis indicates the sensitivity of the criterion of
merit (NPV, IRR, or any other) to variations in basic factors and
provides information of the following type: If the quantity
produced and sold decreases by 1 percent, other things being
equal, the NPV falls by 6 percent.
Such information, though useful, may not be adequate for
decision making. The decision maker would also like to know
the likelihood of such occurrences.
This information can be generated by simulation analysis
which may be used for developing the probability profile of a
criterion of merit by randomly combining values of variables
which have a bearing on the chosen criterion.

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Procedure The steps involved in simulation analysis are as follows:
• Model the project. The model of the project shows how the net present value is
related to the parameters and the exogenous variables.
 Parameters are input variables specified by the decision maker and held
constant over all simulation runs.
 Exogenous variables are input variables which are stochastic in nature and
outside the control of the decision maker.
• Specify the values of parameters and the probability distributions of the
exogenous variables.
• Select a value, at random, from the probability distributions of each of the
exogenous variables.
• Determine the net present value corresponding to the randomly generated
values of exogenous variables and pre-specified parameter values.
• Repeat steps (3) and (4) a number of times to get a large number of
simulated net present values. 4, Plot the frequency distribution of the net present
value.

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In the NPV model embodied in the Equation above, the risk-free rate and the
initial investment are parameters with the following values: risk-free rate = 10
percent and initial investment = Rs. 13,000.

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 Airways Limited Case
Airways Limited has been set up to run an air taxi service in western India. The company is
debating whether it should buy a turboprop aircraft or a piston engine aircraft. The turboprop
aircraft costs 3500 and has a larger capacity. It will serve if the demand turns out to be high.
The piston engine aircraft costs 1800 and has a smaller capacity. It will serve if the demand
is low, but it will not suffice if the demand is high.
The company believes that the chances of demand being high and low in year 1 are 0.6
and 0.4. If the demand is high in year 1, there is an 80 percent chance that it will be high in
subsequent years (year 2 onward) and a 20 percent chance that it will be low in subsequent
years.
The technical director of Airways Limited thinks that if the company buys a piston
engine aircraft now and the demand turns out to be high the company can buy a second-hand
piston engine aircraft for 1400 at the end of year 1. This would double its capacity and
enable it to cope reasonably well with high demand from year 2 onwards.
The payoffs associated with high and low demand for various decision alternatives are
shown in Exhibit 1.1.The payoffs shown for year 1 are the payoffs occurring at the end of
year 1 and the payoffs shown for year 2 are the payoffs for year 2 and the subsequent years,
evaluated as of year 2, using a discount rate of 12 percent which is the weighted average cost
of capital for Airways Limited.
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Exhibit 1.1 Decision Tree Year 1
Year 2
High demand
(0.8) 7000
High demand (0.6)
C Low demand
1000 (0.2)
2
1000

C
High demand
Turboprop 1
(0.4)
- 4000
7000
Low demand (0.4)
C Low demand
200 (0.6)
3
600
High demand
(0.8)
6000
Low demand
D1 C
(0.2)
High demand Expand 5
- 1400 600
(0.6)
D2 High demand
500 (0.8)
Do not
expand 2500
Piston engine
C Low demand
- 1800 (0.2)
6
800
C High demand
4 (0.2)
2500
Low demand (0.4)
C Low demand
300 (0.8)
7 800

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 Airways Limited Solution
If Airways Limited buys the turboprop aircraft, there are no further decisions to be made. So, the NPV of the
turboprop aircraft can be calculated by simply discounting the expected cash flows:
0.6 (1000) + 0.4 (200)
NPV = - 4000 +
(1.12)
0.6 [ 0.8 (7000) + 0.2 (1000) ] + 0.4 [ 0.4 (7000) + 0.6 (600) ]
+ = 389
(1.12) 2

If Airways Limited buys the piston engine aircraft and the demand in year 1 turns out to be high, a further
decision has to be made with respect to capacity expansion. To evaluate the piston engine aircraft, proceed as
follows:
First, calculate the NPV of the two options viz., ‘expand’ and ‘do no expand’ at decision point D2:
0.8(6000) + 0.2 (600)
Expand: NPV = - 1400 = 2993
1.12
0.8 (2500) + 0.2 (800)
Do not expand: NPV = = 1929
1.12
Second, truncate the ‘do not expand’ option as it is inferior to the ‘expand’ option. This means that the NPV at
decision point D2 will be 2923.
Third, calculate the NPV of the piston engine aircraft option.
0.6 (500 + 2923) + 0.4 (300) 0.4 [0.2 (2500) + 0.8 (800)]
NPV = - 1800 + + = 505
(1.12) (1.12)2
Since the NPV of the piston engine aircraft (505) is greater than the NPV of the turboprop aircraft (389), the
former is a better bet. So the recommended strategy for Airways Limited is to invest in the piston engine
aircraft at decision point D1 and, if the demand in year 1 turns out to be high, expand capacity by buying another
piston engine aircraft:
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Value of the Option Note that if Airways Limited does not have the option of expanding capacity at
the end of year 1, the NPV of the piston engine aircraft option would be:
0.6 (500) + 0.4 (300)
NPV = - 1800 +
(1.12)
0.6 [0.8 (2500) + 0.2 (800)] + 0.4 [0.2 (2500) + 0.8 (800)]
+ = 28
(1.12)2
Thus, the option to expand has a value of: 505 – 39 = 466.
Option to Abandon So far we assumed that Airways Limited will continue operations irrespective
of the state of demand. Let us now introduce the possibility of abandoning the operation and
disposing off the aircraft at the end of year 1, should it be profitable to do so. Suppose after 1 year
of use the turboprop aircraft can be sold for 3600 and the piston-engine aircraft for 1400.

If the demand in year 1 turns out to be low, the payoffs for ‘continuation’ and ‘abandonment’ as
of year 1 are as follows.
Turboprop Aircraft Piston Engine Aircraft
Continuation : 0.4 (7000) + 0.6(600) Continuation : 0.2(2500) + 0.8 (800)
= 3160/(1.12) =2821 = 1140/(1.12) = 1018
Abandonment : 3600 Abandonment : 1400

Thus in both the cases it makes sense to sell off the aircraft after year 1, if the demand in year 1
turns out to be low.

The revised decision tree, taking into account the abandonment options, is shown in Exhibit 1.2.

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Exhibit 1.2 Decision Tree Year 1 Year 2

High demand
(0.8)
7000
High demand (0.6)
Low demand
1000
(0.2)
1000
C
Turboprop 1

- 4000 Low demand (0.4)

Sell Turboprop for
200 3600

High demand
D1 (0.8)
6000

High Low demand

Expand
demand - 1400 (0.2)
600
(0.6)
High demand
500 Do not (0.8)
expand 2500

Piston engine
Low demand
- 1800 (0.2)
800

Low demand (0.4)

Sell Piston engine
300 for 1400
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Given the decision tree with abandonment possibilities, let us calculate the NPV of the
turboprop aircraft and the piston engine aircraft.

0.6 [1000 + {0.8(7000) + 0.2 (1000)}/(1.12)] + 0.4 (200 + 3600)

NPV (Turboprop) = -4000 +
(1.12)
= 667

0.6 (500 + 2993) + 0.4 (300 + 1400)

NPV (Piston engine) = -1800 + = 678
(1.12)
Note that the possibility of abandonment increases the NPV of the Turboprop aircraft
from 389 to 667. This means that the value of the option to abandon is:

Value of abandonment option = NPV with abandonment - NPV without abandonment

= 667 - 389 = 278

For the piston engine aircraft the possibility of abandonment increases the NPV from 505
to 678. Hence the value of the abandonment option is 173.

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