Question
In: Finance
The Masterson, Inc. is considering the purchase of a piece of equipment whose upfront cost is...
- The Masterson, Inc. is considering the purchase of a piece of
equipment whose upfront cost is $65 million. The company estimates
that the result of operating this equipment could go one of two
ways: it could be highly successful and produce EBIT of $15 million
in year one and that EBIT grows at 3.42% per year for nine more
years; or it could be a poor performer and produce only $5 million
in EBIT in year one and that will grow by only 2.12% per year over
the remaining useful life of ten years. The machine will be
depreciated on a straight line basis over its useful life down to a
book value of $9 million. The expected salvage value of the machine
at the end of year ten is $11 million. The company’s marginal tax
rate is 25% and its RRR or WACC is 16%. The company assigns a 38%
chance to success.
- Given the above information and based on static analysis, should the company go ahead with its investment?
- Upon further study the company realizes that, if the project proved to be underperforming by the end of year one, the company can stop production and sell the machine for a salvage value of $61 million. Given this information, should the company go ahead with the investment?
- What is the present value of the option to abandon?
Solutions
Expert Solution
A. Possibility of Success = 38%. Therefore, possibility of failure = 62%.
If we draw a diagram of the success or failure it would look like below:
We need to find the cashflow for each of the options and then take a weighted average of the cashflow by multiplying them by the probabilities.
When it is static analysis, it means that once the decision is taken, the entire scenario - till year 10 cannot be changed.
Therefore, the cash flows for the 2 choices are presented below:
When company does well:
when Company does not do well
Therefore, taking the weighted NPV = 38% * 5.20 + 62%*-36.39 = - 20.58 Million. Based on Static Analysis the company SHOULD NOT go ahead with the project. However, if the company stops the project when it goes bad in the first year, then the NPV for failure is as below:
In this case, the weighted NPV = -3.23 Million The value of the option = NPV with the Option - NPV without the option = -3.23 + 20.58 = 17.24 Million |
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when Company does not do well
| EBIT Growth | 2.12% | ||||||||||
| Tax | 25.00% | ||||||||||
| WACC | 16.00% | ||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Investment | (65) | (59) | (54) | (48) | (43) | (37) | (31) | (26) | (20) | (15) | (9) |
| EBIT | 5 | 5.11 | 5.21 | 5.32 | 5.44 | 5.55 | 5.67 | 5.79 | 5.91 | 6.04 | |
| Depreciation | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | |
| Plus: Profit from Sale of Asset | 2 | ||||||||||
| PBT | (1) | (0) | (0) | (0) | (0) | (0) | 0 | 0 | 0 | 2 | |
| Tax | (0.15) | (0.12) | (0.10) | (0.07) | (0.04) | (0.01) | 0.02 | 0.05 | 0.08 | 0.61 | |
| PAT | (0.45) | (0.37) | (0.29) | (0.21) | (0.12) | (0.04) | 0.05 | 0.14 | 0.24 | 1.83 | |
| Plus: Depr | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | |
| Plus: Sale of Asset | 9 | ||||||||||
| Cash Flow | (65) | 5.15 | 5.23 | 5.31 | 5.39 | 5.48 | 5.56 | 5.65 | 5.74 | 5.84 | 16.43 |
| Discount Factor | 1.000 | 0.862 | 0.743 | 0.641 | 0.552 | 0.476 | 0.410 | 0.354 | 0.305 | 0.263 | 0.227 |
| NPV | -36.39 |
Therefore, taking the weighted NPV = 38% * 5.20 + 62%*-36.39 = - 20.58 Million. Based on Static Analysis the company SHOULD NOT go ahead with the project.
However, if the company stops the project when it goes bad in the first year, then the NPV for failure is as below:
| EBIT Growth | 2.12% | |
| Tax | 25.00% | |
| WACC | 16.00% | |
| Year | 0 | 1 |
| Investment | (65) | (59) |
| EBIT | 5.00 | |
| Depreciation | 5.60 | |
| Plus: Profit from Sale of Asset | 2.00 | |
| PBT | 1.40 | |
| Tax | 0.35 | |
| PAT | 1.05 | |
| Plus: Depr | 5.60 | |
| Plus: Sale of Asset | 59.00 | |
| Cash Flow | (65) | 65.65 |
| Discount Factor | 1.000 | 0.862 |
| NPV | -8.41 |
In this case, the weighted NPV = -3.23 Million
The value of the option = NPV with the Option - NPV without the option
= -3.23 + 20.58 = 17.24 Million
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