Question

We are examining a new project. We expect to sell 5,500 units per year at $69 net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be $69 × 5,500 = $379,500. The relevant discount rate is 19 percent, and the initial investment required is $1,540,000. After the first year, the project can be dismantled and sold for $1,260,000. Suppose you think it is likely that expected sales will be revised upward to 8,500 units if the first year is a success and revised downward to 4,100 units if the first year is not a success.

    

a.	If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

NPV

$

  

b.	What is the value of the option to abandon? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Option value

$

Answer 1

a

The success and failure are equally likely in the project, expected value of project in one year would be equal to the avaerage of success or failure in one year plus the cash flow in one year

If Project is a success, present value of cash flow

8500*69*PVIFA(19%,10)

8500*69*(1-(1+r)^-n)/r

8500*69*4.3389

$2,544,785.30

We will have to consider the option of abandon in the project

We would sell the project if the cash flow from selling the project is greater than the present value of cash flows. Therefore, we need to find the sale quantity where this two would be equal

$1260000= 69*(PVIFA19%,10)*Quantity

$1260000 = 69*4.3389*Quantity

Quantity = 4209

Therefore we would abandon the project if the quantity sold is less than 4209

If the revised downward quantity is 4100 which is less than the quanity for project to be abandon, therefore the cash flow would be the amount of abandon if the quantity revises downward

Expected value of project = ((2544785.30+1260000)/2)+379500

$2,281,892.65

b

If the project would have not been abandon, the present value of the cash flows when the quantity is 4100 will be

PV of future Cash flows - 4100*69*PVIFA(19%,10)

4100*69*4.3389

1227474.81

Therefore, gain from abandon = 1260000-1227474.81

32525.19

Value of the option = (0.50)(32525.19)/1.19 = 13666.05