Question

A project has an initial, up-front cost of $10,000, at t = 0. The project is expected to produce cash flows of $2,200 for the next three years. The project’s cash flows depend critically upon customer acceptance of the product. There is a 60% probability that the product will be wildly successful and produce CFs of $5,000, and a 40% chance it will produce annual CFs of -$2,000.

At a 10% WACC, what is this project’s NPV with abandonment option? (Please write down the detailed steps or explanation, not just one number.)

Answer 1

NPV is the profitability of the project. It is the difference between present value of cash inflow - capital outlay.

i.e NPV = PVCI- Capital Outlay

Cashflows are discounted at present value using the discount factor.

We find the PVCI of the project if project is successful.

Discount factor for each year = 1/(1+R)^N

for year 1 = 1/(1+10%)^1 = 0.909

Now we find the PVCI is project is not succesful.

We expect to incur a cash loss of 2000 at end of each year. If we come to know that a project is not successful, we will not continue the project after year 1 and will abandon it.

Hence PVCI = -2000 / 1.1 = -1818.18

Hence Expected PVCI of the project = 60% * Success PVCI + 40% * Not Succesul PVCI

= 60* 12434.26 + (-1818.18 * 40%)

= 6733.28

Now we find the NPV, using the expected PVCI and capital outlay

NPV = PVCI - Capital Outlay = 6733.28 - 10000 = - 3266.72