Question

Acme Co. is considering a four-year project that will require an initial investment of $12,000. The base-case cash flows for this project are projected to be $12,000 per year. The best-case cash flows are projected to be $19,000 per year, and the worst-case cash flows are projected to be –$3,000 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 14%?

$15,424

$17,138

$17,995

$16,281

Acme 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 –$3,000 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.

$22,128

$21,166

$20,204

$19,242

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

1473

2209

2104

1578

1683

Answer 1

What would be the expected net present value (NPV) of this project if the project’s cost of capital is 14%?

$17138 Option B

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

$19242 Option D

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

$2104 (19242-17138) Option C

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