Question

Using Excel (if applicable),

A company is evaluating a project that would require a $5 million investment today (t = 0). The after-tax cash flows would depend on whether a new property tax is imposed. There is a 75% chance that the tax will pass and 25% chance that it won't. If the tax passes, the project will produce after-tax cash flows of $1,200,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1,200,000 cash flow at t = 1 and would also sell the property for $4 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the value of this abandonment option? Should the company take the project? Do not round intermediate calculations.

Answer 1

Tutorial Note: There are broadly 2 questions in the problem, viz.,
1. What is the value of this abandonment option?
2. Should the company take the project?

These 2 questions would be answered in 2 parts, i.e., Part-1 and Part-2

Part-1 : Value of Abondonement Option

Given data:
If the project is abondoned after 1 year, the firm would receive following amounts
1. Expected Cash Flow = $1,200,000
2. Seling Price of Property = $4,000,000

Initial Investment = $5,000,000

Statement Showing NPV of Project if Project is abondoned after Year-1 (Amount in $)

Year	Cash Flow	Present Value Interest Factor @ 12% WACC	Present Value of Cash Flow
0	-5,000,000	1	-5,000,000
1	1,200,000	0.893	1,071,600
1	4,000,000	0.893	3,572,000
			-356,400

Therefore, NPV of the abondonement option is negative 356,400.

Value of Abondonement Option = - $356,400

Part-2 : Decision regarding Accepting the Project

In the given scenarion the company should accept the project only ig the project incurs a positive Net Presnt Value. Hence, in order to advice regarding acceptance of the project we need to calculate the NPV of the project.

Given data:
Initial investment = $5,000,000

Again, tax cash flows would depend on whether a new property tax is imposed. There is a 75% chance that the tax will pass and 25% chance that it won't. If the tax passes, the project will produce after-tax cash flows of $1,200,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years.
Hence, effective probable cash flow each year = $1,400,000 (Refer Working Note-1)

Statement Showing NPV of Project if Project for %years life (Amount in $)

Year	Cash Flow	Present Value Interest Factor @ 12% WACC	Present Value of Cash Flow
0	-5,000,000	1	-5,000,000
1 to 5	1,400,000	3.605	5,047,000
			47,000

Hence, NPV of the project = $47,000

Advise: Since the project has a positive NPV; the project should be accepted.

Working Note-1 : Computation of Effective Probale Cash Flow

We know, Effective Probale Cash Flow = Varities of Cash Flows * Respective Probability Factors

Hence, in this case = ($1,200,000 * 75%) + ($2,000,000 * 25%) = $1,400,000