Question

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. 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

(i)The NPV of the project is calculated as follows:

Particulars	In Case of Success (A)	In Case of Failure(B)
Expected Sales (A)	10800 units	3900 units
Selling Price per unit (B)	$56	$56
Total Cash Flow(A*B)	$604800	$218400
Discounting factor at 14% for 10 years	5.21612	5.21612
Cash Inflow (C)	$3154709	$1139200
Initial Investment (D)	$1800,000	$1800,000
Net Present Value (C-D)	$1354,709	-$660,800

An abandonment value refers to the cash value earned on a project after it has been abandoned or discontinued. A project or an asset can be abandoned (liquidated or sold) if its net present value of expected cash flow is lower than the amount received for salvage.

In the given case Option B that is in case of failure the project should not be continued and exercise the option of  abondon as NPV is negative.

(ii)An abandonment option is a clause in an investment contract granting parties the right to withdraw from the contract before maturity. It adds value by giving the parties the ability to end the obligation if conditions change that would make the investment unprofitable.

It is calculated as follows:

NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future

= $1139200/[(1+14%)^10]

=$1139200/1.14^10

=$307,292