Question

Galbraith Co. is considering a four-year project that will require an initial investment of $12,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $20,000 per year, and the worst-case cash flows are projected to be a -$2,500 per year. The company's analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

What would be the expected net present value (NPV) of this project if the project's cost of capital is 10%?

(a) $22,365 (b) $26,093 (c) $24,850 (d) $19,880

Galbraith now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,000 (at the end of year 2). The $4,000 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project's assets and the company's -$2,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

(a) $227.089 (b) $24,380 (c) $29,798 (d) $31,152

What is the value of the option to abandon the project?

(a) $1,567 (b) $2,239 (c) $2,351 (d) $2,463 (e) $1,791

Answer 1

Scenario 1:

Expected cash flow per year= 50%*14000+25%*20000+25%*(-2500)=$11375

Now, below is the calculation for the NPV:

Year	Cash Flow	Present Value (CashFlow/1.1^year)
0	(12,000.00)	(12,000.00)
1	11,375.00	10,340.91
2	11,375.00	9,400.83
3	11,375.00	8,546.21
4	11,375.00	7,769.28
	NPV (Total of Present Value)	24,057.22

So, Expected NPV is $24057.22

Scenario 2:

When the project is abandoned at the end 2nd year, below is the calculation for NPV:

Year	Cash Flow	Present Value (CashFlow/1.1^year)
0	(12,000.00)	(12,000.00)
1	(2,500.00)	(2,272.73)
2	4,000.00	3,305.79
	NPV (Total of Present Value)	(10,966.94)