Question

You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $60 million per year for three years (starting next year, i.e., at t = 1). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until the first year's cash flows are in, i.e., at t = 1. You have to spend $90 million immediately for equipment and the rights to produce the figure. If you can sell your equipment for $60 million immediately after the first year's cash flows are received, calculate Hillary's NPV with this abandonment option. (The discount rate is 10%. The equipment can only be resold at the end of the first year.) The 3-year annuity factor at 10% equals 2.48685.

Can someone show step by step, knowing that the Truck of 60 million dollars can be sold after the 1rst years Cash flows are received ?

Answer 1

NPV with abandonment option:

PV(success) = 60(2.48685) = 149.2110million

PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 million(assuming that the equipment will be sold if the action figure is a failure)

Npv= -90 + (149.211)(0.5) + (63.6364)(0.5) =16.4237million