Question

[Abandonment] We are examining a new project. We expect to sell 7,100 units per year at $56 net cash flow apiece for the next 10 years. In other words, the annual cash flow is projected to be $56*7,100=$397,600. The relevant discount rate is 14%, and the initial investment required is $1,800,000. Suppose you think it is likely that expected sales will be revised upward to 10,800 units if the first year is a success and revised downward to 3,900 units if the first year is not a success. After the first year, the project can be dismantled and sold for $1,200,000

<To calculate expected PV1 (after 1st year) you need to get PV1 of a successful case and PV1 of a not successful case. If the project is not successful, you will sell the project for $1,200,000. Therefore, the expected cash flow will be equally-weighted average of "10,800* PV1 of (N=9, PMT=56, I/Y=14, FV=0)=2,991,565.7" and "1,200,000" PLUS 397,600 at year 1. so, to calculate NPV at time 0, you need to discount Time 1 value to PV and subtract the cost (1,800,000)>

i. If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering.

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

Answer 1

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