Question

Applied Nanotech is considering a project that involves developing a new machine. The marketing department believes that there is a 50% chance that the project will generate annual cash flows of $810,000 per year for five years (Years 1 through 5). On the other hand, there is a 50% chance that the project will be unsuccessful and generate annual cash flows of -$200,000 per year for five years. The engineering department has come up with the estimate that developing the machine will require a $1 million initial investment (Year 0). The finance department has estimated that a 25 percent discount rate should be used. The firm has the option to abandon the project in Year 1 (after the Year 1 cash flow is realized). If abandoned, the project would have no salvage value.

1.What is the NPV of the project, after accounting for the abandonment option? Round your final answer to the nearest dollar.

a.-179,770 b. 9,158 c. 1,178,317 d.188,928 3.-1,160,000

2.What is the value of the abandonment option? Round your final answer to the nearest dollar.

a.1,537,856 b.-1,160,000 c.188,928 d.1,178,317 e.9,158

Answer 1

NPV = PV of Cash In flows - PV of Cashout flows

NPV of Project If Cash flows are $ 810,000:

= PV of Cash inflows - PV of Cashout flows

= Cash flow * PVAF (r%, n) - $ 1,000,000

= $ 810,000 * PVAF (25%, 5) - $ 1,000,000

= $ 810,000 * 2.6893 - $ 1,000,000

= $ 2,178,316.80 - $ 1,000,000

= $ 1,178,316.80

NPV of Project If Cash flows are $ -210,000:

= PV of Cash inflows - PV of Cashout flows

= Cash flow * PVAF (r%, n) - $ 1,000,000

= $ -200,000* PVAF (25%, 5) - $ 1,000,000

= $ -200,000 * 2.6893 - $ 1,000,000

= $ -537,856 - $ 1,000,000

= $ -1,537,856

NPV of Project If Cash flows are $ -200,000 & with abondonment option:

with this option you can stop the project at the end of the 1st year & Cash flows for 2 to 5 Years will not be there

= PV of Cash inflows - PV of Cashout flows

= Cash flow * PVF (r%, n) - $ 1,000,000

= $ -200,000 * PVF (25%, 5) - $ 1,000,000

= $ -200,000 * 0.8000 - $ 1,000,000

= $ -160,000 - $ 1,000,000

= $ -1,160,000

Part 1: NPV of Project WIth Abondenment Option:

Option B is correct

Part 2:

NPV of Project without abondonment option:

Value Of Abondonment = NPV with abondonment - NPV without Abondonment

= $ 9158.40 - (179,769.60)

= $ 188,928

Option C is corect.