Question

Broadway Inc. is considering a new musical. The initial investment required is $2,450,000. Every year, the free cash flow from the project is expected to be $350,000, continuing forever.

Investments with similar risk deliver a rate of return of 6%.

1.What is the NPV of the project?

2.In fact, the annual cash flow of $350,000 is an expected value: there is a 50% chance that annual cash flow will be $787,500 and a 50% chance that it will be -$87,500. What is the expected NPV of the project if the company cannot abandon the project?

3.What is the true NPV of the project if the company can abandon the project after the first year?

4.What is the value of the option to abandon?

Answer 1

1.

Computation of PV of Cash Outflows:

Initial Investment = $2,450,000

Therefore, Present Value of Cash Outflows = $ 2,450,000

Computation of PV of Cash Inflows:

PV of Cash outflows = $350,000 * PV of Perpetuity

PV of Cash outflows = $350,000 / 6%

PV of Cash outflows = $5,833,333.33

Computation of NPV:

NPV = PV of Cash Inflows - PV of Cash Out flows

NPV = $5,833,333.33 - $2,450,000

NPV = $3,833,333

(2)

Probability	PV of Cash Outflow	Annual Cashflow	PV of Cash Inflows	NPV	Expected NPV
A	B	C	D = C/6%	E = D - B	E = A*E
50%	$2,450,000	$787,500	$13,125,000	$10,675,000	$5,337,500
50%	$2,450,000	($87,500)	($1,458,333)	($3,908,333)	($1,954,167)
			Expected NPV	$3,383,333

(3)

Probability	PV of Cash Outflow	Annual Cashflow	PV of Cash Inflows	NPV	Expected NPV
A	B	C	D	E = D - B	E = A*E
50%	$2,450,000	$787,500	$13,125,000 (C/6%)	$10,675,000	$5,337,500
50%	$2,450,000	($87,500)	($82,547) (C/1.06)	($2,532,547)	($1,266,274)
			Expected NPV	$4,071,226

(4)

Value of Option of Abandonment = NPV under Abandonment Option - NPV without abandonment Option

Value of Option of Abandonment = (3) - (2)

Value of Option of Abandonment = $687,893