Question

In: Finance

Abandonment option: Consider a 3-year project with a 14.00% cost of capital. The initial investment is...

Abandonment option: Consider a 3-year project with a 14.00% cost of capital. The initial investment is $1,000 and the expected cash flows are $400 per year.

a. Calculate NPV and determine whether or not to undertake this project.

b. Suppose instead that we have more information on the expected cash flows. First, there is a 40.00% probability that the project is a success and the cash flows will be $700 and a 60.00% probability that the project is a failure and the cash flows will be $200. In addition, at the end of the first year, we will know whether the project is a success or a failure. We have the option to abandon the project at the end of the first year and receive the salvage value of $850. First, determine the optimal abandonment strategy. Then calculate the project's NPV and the value of the abandonment option using that strategy

Requirement:

What is the value of Abandonment option?

Solutions

Expert Solution

(a) NPV = Present value of cash inflow - initial investment

=[ 400/(1+0.14) + 400/(1+0.14)2 + 400/(1+0.14)3 ] - 1000

= [ 350.88 + 307.78 + 269.99 ] - 1000

= 928.65 - 1000

= - 71.35

Since NPV is negative therefore do not undertake this project.

(b) Evaluation at the end of first year :

Situation-1: If project is sucessful i.e. cash inflow = 700

Present value of expected cash inflow at the end of first year = 700/(1+0.14) + 700/(1+0.14)2

= 614.04 + 538.63

= 1152.67

Since present value of expected cash inflow at the end of first year (i.e. 1152.67) is more than Salvage Value at the end of first year (i.e. 850) therefore abandonment option should not be opt.

Situation-2: If project is fail i.e. cash inflow = 200

Present value of expected cash inflow at the end of first year = 200/(1+0.14) + 200/(1+0.14)2

= 175.44 + 153.89

= 329.33

Since present value of expected cash inflow at the end of first year (i.e. 329.33)  is less than Salvage Value at the end of first year (i.e. 850) therefore abandonment option should be opt.

Hence revised NPV = [ (700+1152.67) 0.40 + (200+850) 0.60 ] / (1 + 0.14) - 1000

= [ 1852.67 0.40 + 1050 0.60 ] / (1 + 0.14) - 1000

= [ 741.068 + 630 ] / (1 + 0.14) - 1000

= 1371.068 / (1 + 0.14) - 1000

= 1202.69 - 1000

= 202.69

Since Revised NPV is positive therefore undertake the project with abandonment option.

Therefore value of Abandonment Option = Revised NPV - Original NPV

= 202.69 - (- 71.35)

= 202.69 + 71.35

= 274.04

jeff jeffy answered 2 years ago
Next > < Previous

Related Solutions

3. Abandonment options Acme Co. is considering a four-year project that will require an initial investment...
3. Abandonment options Acme Co. is considering a four-year project that will require an initial investment of $15,000. The base-case cash flows for this project are projected to be $15,000 per year. The best-case cash flows are projected to be $22,000 per year, and the worst-case cash flows are projected to be –$1,500 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...
3. Abandonment options Albert Co. is considering a four-year project that will require an initial investment...
3. Abandonment options Albert Co. is considering a four-year project that will require an initial investment of $7,000. The base-case cash flows for this project are projected to be $12,000 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 –$1,000 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...
Consider a project that has a 10% cost of capital that requires an initial investment of...
Consider a project that has a 10% cost of capital that requires an initial investment of $10,000. The year 1 net cash inflow is $2,450; the year 2 net cash inflow is $2,850; the year 3 net cash inflow is $3,350; the year 4 net cash inflow is $3,750; and the year 5 net cash inflow is $5,250. What is the project's discounted payback? NPV? AND IRR?
8. Abandonment options Galbraith Co. is considering a four-year project that will require an initial investment...
8. Abandonment options Galbraith Co. is considering a four-year project that will require an initial investment of $15,000. The base-case cash flows for this project are projected to be $15,000 per year. The best-case cash flows are projected to be $22,000 per year, and the worst-case cash flows are projected to be –$1,500 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...
3. Consider a project with a 6-year life. The initial cost to set up the project...
3. Consider a project with a 6-year life. The initial cost to set up the project is $1,200,000. This amount is to be linearly depreciated to zero over the life of the project. You expect to sell the equipment for $240,000 after 6 years. The project requires an initial investment in net working capital of $120,000, which will be recouped at the end of the project. You estimated sales of 57,000 units per year at a price of $167 each....
Consider the following capital investment proposal: It requires an initial investment of $1,170 million. The project...
Consider the following capital investment proposal: It requires an initial investment of $1,170 million. The project is expected to generate the following net cash flows: $417 million in year 1 $328 million in year 2 $475 million in year 3 $531 million in year 4. If the company uses a discount rate of 11%, how much is the profitability index? Enter your answer in millions. Round to one decimal. Please show work
87. Should the following project be accepted if the cost of capital is 12%? Initial Investment...
87. Should the following project be accepted if the cost of capital is 12%? Initial Investment is $50,000. ​ Years Cash Flows 1 $25,000 2 $35,000 3 $55,000 a. Yes, because the internal rate of return is 10.5%, which is less than 12%. b. Yes, because the internal rate of return is 35%, which is more than 12%. c. No, because the internal rate of return is 8.7%, which is less than 12%. d. Yes, because the internal rate of...
Aramark is considering a 3-year project with an initial cost of $570,000. The project will not...
Aramark is considering a 3-year project with an initial cost of $570,000. The project will not directly produce any sales but will reduce operating costs by $147,000 a year. The equipment is classified as MACRS 7-year property. The MACRS table values are .1429, .2449, .1749, .1249, .0893, .0892, .0893, and .0446 for Years 1 to 8, respectively. At the end of the project, the equipment will be sold for an estimated $295,000. The tax rate is 25 percent and the...
Consider a project with a 6-year life. The initial cost to set up the project is...
Consider a project with a 6-year life. The initial cost to set up the project is $450,000. This amount is to be linearly depreciated to zero over the life of the project. The firm expects to be able to sell the equipment for $90,000 after 6 years. The price per unit is $380, variable costs are $304 per unit and fixed costs are $45,000 per year. The project has a required return of 12% and a tax rate of 28%....
Consider a project with a 6-year life. The initial cost to set up the project is...
Consider a project with a 6-year life. The initial cost to set up the project is $1,200,000. This amount is to be linearly depreciated to zero over the life of the project. You expect to sell the equipment for $240,000 after 6 years. The project requires an initial investment in net working capital of $120,000, which will be recouped at the end of the project. You estimated sales of 63,000 units per year at a price of $160 each. The...
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT