Question

a. SI Inc. is considering investing in a new product named Z90. There is a 50% chance that the product will be a success, which then generates $110,000 cash inflow each year for the next 5 years. There is a 50% chance that the product will fail, which then generates $25,000 cash inflow each year for the next 5 years. The project requires an initial investment of $250,000. Based on the above information, what is the expected net present value of this Z90 project if the cost of capital is 12%?

b. Now, assume that one year from now, SI Inc. will know whether the Z90 has become the industry standard. Assume also that after receiving the cash flow at t = 1, SI Inc. has the option to abandon the Z90 project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?

Please include calculations and formulas suing Excel to better understand the solution set.

Answer 1

Solution:-

(a) NPV of the project= Probability of Success* NPV of present value of cash inflow if successful - Cash outflow

Present value of cash outflow=$250,000
Present value of cash Inflow if Sucessfull = Annaul cash flow*PVAF(r,n)
=110,000*PVAF(12%,5 years) =110,000*3.605 = $396,550
NPV of the project= 50%(396,550 - 250,000) =$73,275

(b) Estimated value of the abandonment:

By abandoning project we receive salvage value of $100,000 and 1 year cash flow but give up cash flows for remaining 4 years. Therefore optimal strategy is to abandon the project at the end of the first year if PV of remaining cashflows in 4 years is less than the salvage value .

PV of remaining cashflow in 4 years

year	cash inflow	PVF@12%	PV
2	110,000	0.797	87670
3	110,000	0.712	78320
4	110,000	0.636	69960
5	110,000	0.567	62370
Present value of cash inflow at year 1			$298,320

value of the abandonmen = salvage value of $100,000 + First year cash flow
=$100,000+110,000 = $210,000

PV of remaining cashflows in 4 years is more than the salvage value therefore it is not suggested to abondoning the project.

  

**Please Do Like* Thank You**