Question

Porter Climate Control is evaluating a proposal to move some manufacturing operations from an obsolescent plant in Illinois to a new facility in Mexico. The new facility will cost $58 million to open. and is expected to result in savings of $16 million per year for the first five years. At the end of 5 years, Porter will decide either to close the plant in Mexico or to keep it indefinitely. If Porter closes the plant, the building and equipment can be sold for $20,000,000. If the plant is kept, assume that the $16 million turns into a perpetuity. There is a 30% chance the plant will be closed and a 70% chance it will be kept. Compute the expected NPV of the project. Use a discount rate of 12%.

a $75.32 million

b ($30.32 million)

c $56.04 million

d $114.04 million

Answer 1

Solution:             

Option 1 : Close the plant after 5 years

The NPV of the option to close the plant is = $ 11.02 Million

Thus the NPV of Option 1 i.e, to close the plant = $ 11.02 Million

Please find the attached screenshot of the excel sheet containing the detailed calculation for the above

Option 2 : Keep the plant

As per the information given in the question

Discount rate given = 12 % = 0.12

If the plant is kept, it is assumed that the $16 million turns into a perpetuity.

Thus the PV of cash Inflows of $ 16 million to perpetuity

= Cash flow / r              ( where r is the discount rate )

= $ 16 Million / 0.12 = $ 133.33 Million

The Initial cash outflow = $ 58 Million

The NPV of the option to keep the plant

= PV of cash Inflows of $ 16 million to perpetuity - Initial cash outflow

= $ 133.33 Million - $ 58 Million

= $ 75.33 Million

Thus the NPV of Option 2 i.e, to keep the plant = $ 75.33 Million

Calculation of expected NPV:

As per the information given in the question :

There is a 30% chance the plant will be closed and a 70% chance it will be kept.

Thus expected NPV = ( 30 % * NPV of Option 1 ) + ( 70 % * NPV of Option 2 )

= ( 30 % * 11.02 ) + ( 70 % * 75.33 )

= 3.31 + 52.73 = 56.04

Thus the expected NPV of the project = $ 56.04 Million

Thus the solution is Option c. $ 56.04 Million