Question

Your firm is evaluating a new $725,000 investment opportunity with a 16% required return. You expect to sell 3,500 units per year at $50 net cash flow each for the next 8 years. Suppose that after one year, you will know more about demand and be able to revise your estimate of future unit sales based on sales you observe for year 1. Further, suppose that the project can be dismantled and sold to net $650,000 at that time.

a. What is the minimum level of unit sales for year 1 below which would it make sense to abandon the project?

b. If the original expectation of 3,500 unit sales is the average of two equally likely outcomes (3,000 units or 4,000 units), what is the value of the project, including the option to abandon at the end of the first year?

Answer 1

a. Refer following screenshot for answer a. There are two approaches to the solution and I have put both for your reference.

b. Refer following screenshot for answer b.

AS Y . ab = NPV.xlsx - Excel 0 0 - A X Share O Ruler Formula Bar Q a 3 E B Switch Wind Macros Macros M N P Q R s a File Home Insert Page Layout Formulas Data Review View Power Pivot Tell me what you want to do... 22 - Split View Side by Side Hide El Synchronous Scrolling Normal Page Break Page Custom → Gridlines Headings Zoom 100% Zoom to New Arrange Freeze Preview Layout Views Selection Window All Panes Unhide E Reset Window Position Workbook Views Show Zoom Window A1 : X for - A B C D E F G H I K L Discounting Year Cash Flow Factor PVCF 175,000 0.86 150,862 Initial Investment 725,000 175,000 0.74 130,054 Required Rate of Return 16.00% 175,000 0.64 112,115 Sales Units per year 3,500 175,000 0.55 96,651 Net Cash Flow per unit 175,000 0.48 83,320 Total Annual Net Cash Flow 175,000 175,000 0.41 71,827 PV of Net Cash Flow for the next 8 years 760,128 175,000 0.35 61,920 175,000 0.31 53,379 10 Total PVCF 760,128 11 Minimum level of sales required is when the PVCF is equal to the Initial Investment 12 sum of all Discounting Factors 4.34 13 PVCF for minimum sales 725,000 Annual Cash Flow at minimum sales PVCF for minimum sales / sum of all discounting factors Annual Cash Flow at minimum sales 166,913 Sales Price per unit 50 Minimum Sales units 3,338 WN o 14 Therefore, below 3338 units, it would make sense to abandon it. Alternate theory: However, since the terminal value as at year 1 is USD 650,000, there is additional buffer to have lower sales in year 1 alone. Minimum sales required for alternate theory 725000 - 650000 Minimum net cash flow in alternate theory 75,000 Sales Price per unit 50 Minimum Sales units 1,500 Sheet2 Sheet1 + Ready @ -- 8:44 PM A 29 26/03/20209