Question

Herman Co. is considering a four-year project that will require an initial investment of $15,000. 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 $26,000 per year, and the worst-case cash flows are projected to be –$4,500 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.

What would be the expected net present value (NPV) of this project if the project’s cost of capital is 12%?

A.) $21,458

B.) $25,975

C.) $24,846

D.) $22,587

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 $3,000 (at the end of year 2). The $3,000 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 –$4,500 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.

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

A.) $28,158

B.) $31,998

C.) $30,718

D.) $25,598

What is the value of the option to abandon the project?

A.) $2,108

B.) $2,710

C.) $2,258

D.) $3,011

E.) $2,559

Answer 1

	Base	Best	Worst
Npv with 12%	42522.89	78971.08	-13668.07
	PV(12%,4,-14000)	PV(12%,4,-26000)	PV(12%,4,4500)
Initial Outflow	-15000.00	-15000.00	-15000.00
NPV	27522.89	63971.08	-28668.07
	SUM(D16+D14)	SUM(E16+E14)	SUM(F16+F14)
Probebility	0.50	0.25	0.25
Probebiltiy discoutned cash flow	13761.45	15992.77	-7167.02
	SUM(F16+F14)	E20*E18	F20*F18
Expecte probble NPV	22587.20
	D22+E22+F22

Hence option D is correct.

B)

	Base	Best	Worst
Npv with 12%	42522.89	78971.08	-4017.86
	PV(12%,4,-14000)	PV(12%,4,-26000)	PV(12%,2,4500)
Initial Outflow	-15000.00	-15000.00	-15000.00
additional terminal cash flow at end of 2 years of rs 3000 discounted with 12%			2,391.58
NPV	27522.89	63971.08	-16626.28
	SUM(D16+D14)	SUM(E16+E14)	SUM(F16+F14)
Probebility	0.50	0.25	0.25
Probebiltiy discoutned cash flow	13761.45	15992.77	-4156.57
	SUM(F16+F14)	E20*E18	F20*F18
Expecte probble NPV	25597.65
	D22+E22+F22

Hence option D is correct.

3)

Value of worst condition in Table A	-7167.00
Value of worst condition in Table b	-4156.00
value of abondening project at end of the 2 nd year	-3011.00

Hence option D is correct..