Question

Nippon Inc is considering a project that has an up-front cost of $500,000. The project’s subsequent cash flows depend on whether its products become the industry standard. There is a 60% chance that products will become the industry standard, in which case the project’s expected cash flows will be $120,000 per year for the next 7 years. There is a 40% chance that products will not become the industry standard, in which case the project’s expected cash flows will be $60,000 a year for the next 7 years. Assume the cost of capital is 8%.

a.) Calculate NPV of the project.

b.) Assume that 3 years from now, Nippon will know if its product will have become the industry standard. The firm has the option to abandon the project after receiving the cash flows at t = 3, and the abandonment option does not affect the cost of capital. If the firm decides to abandon the project, it will receive additional $350,000 at t = 3, but will no longer receive any cash flows after that. What is the estimated value of the abandonment option?

ans for part a is -188.47 and part b is:25,242

Answer 1

A.) The NPV of the project is -188.47

Initial investment = $500,000

Cash flows calculation: -

	Probability (P)	Cash flows (C)	Expected cash flows (P*C)
Become industry standard	60%	$120,000	$72,000
Not become industry standard	40%	$60,000	$24,000
			$96,000

The expected cash flow = $96,000

NPV = expected cash flow * (PVIFA 8%, 7) – initial investment

NPV = ($96,000 * 5.20637) - $500,000

NPV = $499,811.52 - $500,000

NPV = -188.47

B.) The NPV of the project is 25,242

Here the project is terminating at year 3, therefore the cash flows from projects are as follows; -

1. Initial investment = $500,000

2. Expected cash flow of $96,000 for 3 years

3. additional lump sum payment at year 3 = $350,000

NPV calculation: -

NPV = Expected cash flow * (PVIFA 8%, 3) + additional inflow * (PVIF 8%, year 3) – initial investment

NPV = ($96,000 * 2.577096) + ($350,000 * .79383) - $500,000

NPV = ($247,401 + $277,840.5) - $500,000

NPV = $525241.5 - $500,000

NPV = 25,242