Suryodaya Ceramics: When the Abandonment Option Reverses a Negative NPV
Suryodaya Ceramics Ltd is evaluating a ₹500 crore greenfield tile plant at Morbi. The finance team's base case uses a 15% risk-adjusted discount rate over a five-year explicit horizon and assumes annual after-tax operating cash flow of ₹220 crore if the export market stays strong and ₹60 crore if it stays weak. Because the team could not agree on probabilities, it simply used the average, ₹140 crore a year, and arrived at a negative NPV. The marketing head objects on two grounds: the strong/weak outcome is actually resolved by the end of Year 1, with equal probability, and if the weak state materialises the land and buildings - but not the machinery, which is purpose-built and has no resale market - could be sold at the end of Year 1 for ₹350 crore net of taxes and dismantling costs. The CFO is sceptical of 'option language' but is willing to value abandonment on the same footing as the base case. All cash flows arise at year-end.
1. Compute the NPV of the project on the finance team's base case and then on a decision-tree basis incorporating the abandonment option. Should the plant be built?
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Annuity factors at 15%
- 5 years: (1 − 1.15⁻⁵) ÷ 0.15 = 3.3522
- 4 years: (1 − 1.15⁻⁴) ÷ 0.15 = 2.8550
Base case (no abandonment)
- PV of ₹140 crore for 5 years = 140 × 3.3522 = ₹469.31 crore
- NPV = 469.31 − 500 = −₹30.69 crore → reject
With the abandonment option
The choice is made at the end of Year 1, after observing the state.
- Weak state: continuing is worth 60 × 2.8550 = ₹171.30 crore, against ₹350 crore on sale. Rational management abandons; cash in at t=1 = 60 + 350 = ₹410.00 crore.
- Strong state: continuing is worth 220 × 2.8550 = ₹628.10 crore, far above salvage. Continue; cash in at t=1 = 220 + 628.10 = ₹848.10 crore.
- Expected value at t=1 = 0.5(848.10) + 0.5(410.00) = ₹629.05 crore
- PV today = 629.05 ÷ 1.15 = ₹547.00 crore
- NPV = 547.00 − 500 = +₹47.00 crore → accept
Verdict. Build. The option value is 47.00 − (−30.69) = ₹77.69 crore, which is the value of managerial flexibility to exit a purpose-built asset whose operating cash flow cannot service its cost of capital. Note that the ₹500 crore of machinery is entirely sunk; the recoverable ₹350 crore sits in land and buildings, which is precisely why site ownership and a saleable title matter at the appraisal stage.
2. At what salvage value does the company become indifferent between abandoning and continuing in the weak state? And what is the minimum Year-1 salvage value that makes the project's overall NPV non-negative?
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Indifference salvage in the weak state
Abandon if salvage S exceeds the PV of continuing in that state:
- 60 × 2.8550 = ₹171.30 crore
Below ₹171.30 crore the company would keep operating even in the weak state, and the abandonment option would be worthless. This is a useful stress point: a market correction in industrial land prices of more than about 51% (from ₹350 crore to ₹171.30 crore) would wipe out the entire strategic case for the plant.
Break-even salvage for overall NPV = 0
Set the expected t=1 value equal to 500 × 1.15 = ₹575 crore:
- Strong state branch (unchanged): 848.10
- Weak state branch: 60 + S
- 0.5(848.10) + 0.5(60 + S) = 575
- 424.05 + 30 + 0.5S = 575
- 0.5S = 120.95 → S = ₹241.90 crore
Interpretation. The project stays viable for any realisable land-and-building value above ₹241.90 crore, provided the exit is genuinely available at the end of Year 1 - roughly 69% of the ₹350 crore appraisal. Between ₹171.30 crore and ₹241.90 crore the option is still exercised in the weak state but is not sufficient to justify the initial outlay. The board should therefore treat the ₹350 crore valuation as an assumption to be independently tested (comparable land transactions, zoning permission for an alternative use, and time-to-sale) rather than as a given.
3. The CFO asks how much confidence is needed in the 'strong market' probability for the project to break even on an option-inclusive basis, and whether the 15% discounting of decision-tree cash flows is theoretically sound. Comment on both.
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Break-even probability
Let p be the probability of the strong state. Expected t=1 value = p(848.10) + (1−p)(410.00) = 410.00 + 438.10p.
Setting the PV equal to ₹500 crore:
- (410.00 + 438.10p) ÷ 1.15 = 500
- 410.00 + 438.10p = 575
- p = 165 ÷ 438.10 = 0.3766, i.e. 37.7%
So the project breaks even even if the odds of a strong export market are as low as 38%, against the 50% assumed. That is the practical value of the option: it truncates the left tail and therefore lowers the probability hurdle the project must clear.
On the discounting
Theoretically the 15% rate is a risk-adjusted rate applied to a single probability-weighted stream. Using it again on a decision tree that has already removed the downside double-counts risk in one direction: the abandonment branch is a management decision, not a market risk, and should properly be discounted at the risk-free rate on risk-neutral probabilities. The standard exam convention - discounting expected decision-tree cash flows at the project's risk-adjusted rate - is conservative and therefore directionally safe here (it understates the option's value), but the CFO should know the NPV of ₹47.00 crore is a floor, not a point estimate.
The bigger caveat is behavioural: the ₹350 crore salvage is an appraisal, not a bid, and the c.₹77.69 crore option value collapses to zero the moment the plant is built and the land is encumbered. Before sanctioning, the board should secure an independent land valuation and confirm that the exit does not breach any term-loan covenant.