Comments
The role of accounting is to report what has happened.
• Accounting does not track what else might have happened
• Accounting does not track opportunity cost
• Accounting does not estimate the future cash for the projects
When management takes on a project, accounting doesn’t know anything about management’s
expectations for the project. Accounting only reports the outcome at the end of each period, say,
yearly. Accounting provides an opportunity for management to reflect on whether the actual outcome
is in line with management’s expectations. The actual outcome is what accounting reports.
Management’s expectation is management’s.
Part ‘a’ provides a baseline situation where management must stick with the project, no matter whether
the outcome is good or bad.
An expected value is the outcome multiplied by the probability of the outcome. Here is an example.
Suppose there is a 50/50 chance of receiving $100 or $200. The expected value is
0.5*$100 + 0.5*$200=$150.
Part ‘b’ sets up the condition where management has the opportunity to switch to a new project if the
first project is turning out poorly. If the outcome for the project is bad on December, 20X1, Pujols will
switch projects if a better project is available. If the outcome is good on December, 20X1, the Pujols will
stick with the existing project. Accounting provides feedback about the project, provoking the Pujols
management to reflect on whether to continue or switch.
Problem Statement
On January 1, 20X1, Pujols Industries has the opportunity to invest in a project with an uncertain
outcome. The product might be a hit and highly profitable, or it might not. To put specific numbers to
it, there is a 50 percent chance that the payoffs will be an annuity of $1,500 per year for three years.
There is also a 50 percent chance that the payoffs will be an annuity of $500 per year for three years.
The payoff on December 31, 20X1 is when Pujols discovers whether the product is a hit or not. If the
payoff is $1,500, then the other two years will also be $1,500. If the payoff is $500, then the other two
years will also be $500.
Because Pujols does not know whether the product will be a hit or not, Pujols assigns 50/50 chances to
the $1,500 and the $500.
The alternative use of money is to invest it at 10 percent.
Required
a. What is the expected present value of the project as of January 1, 20X1?
b. As it happens, the land, building, and equipment have alternative uses, which means that anytime
during the project, Pujols could stop the project and turn to an alternative project (project 2).
Management has already selected a project at January 1, 20X1. This alternative project would only be a
choice if the original project was turning out poorly, say, after the results of the original project were
known on December 31, 20X1. If numbers were put to it, Pujols anticipates that this alternative project
would last the remaining two years and have a present value of $1,600 as of December 31, 20X1. Were
Pujols to swith on December 31, 20X1, Pujols would have the new project (project 2) worth $1,600 plus
the $500 from the first year of the the original project (total of $2,100).
With the opportunity to switch, Pujols has a 50 percent chance of the three year annuity of $1,500.
Pujols also has a 50 percent chance of $2,100 in one year.
What is the present value as of January 1, 20X1 when Pujols has an opportunity to switch?
c. What is the value of January 1, 20X1 of being able to opt out of this first project if it turns out to have
a low payoff? The value of this option is the increase in present value of part b. compared to part a. I
think this is sometimes called the value of the abandonment option.
