Question

Herman Co. is considering a four-year project that will require an initial investment of $9,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $21,000 per year, and the worst-case cash flows are projected to be –$2,500 per year. The company’s analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

1) What would be the expected net present value (NPV) of this project if the project’s cost of capital is 13%?

$29,416

$28,137

$23,021

$25,579

Herman now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $3,500 (at the end of year 2). The $3,500 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project’s assets and the company’s –$2,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

2) Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

$28,949

$34,463

$33,084

$27,570

3) What is the value of the option to abandon the project? 1,692 / 1,792 / 1,394 / 1,991 / 1,493?

Answer 1

Expected cash flows = Probability of Base case * Base case cash flow + Probability of Best case * Best case cash flow + Probability of worst case * Worst case cash flow