6. We are examining a new project. We expect to sell 5,700 units per year at $71
ID: 1172174 • Letter: 6
Question
6. We are examining a new project. We expect to sell 5,700 units per year at $71 net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be $71 x 5,700 $404,700. The relevant discount rate is 15 percent, and the initial investment required is $1,680,000. After the first year, the project can be dismantled and sold for $1,500,000. Suppose you think it is likely that expected sales will be revised upward to 8,700 units if the first year is a success and revised downward to 4,300 units if the first year is not a success. a. If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) NPV $ 9234915 b. What is the value of the option to abandon? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Option value 7243307.29Explanation / Answer
(a) After year1. there are three possible pathways, namely sales increases to 8700 units, sales decreased to 4300 units and project is sold for $ 1500000. The possibility of a sales rise and fall have equal probabilities. Discount Rate = 15 %, Project Tenure = 10 years.
Option1: Sale Units = 8700 and Cash Flow per piece = $ 71
Net Cash Flow (NCF) = 71 x 8700 = $ 617700
PV of NCFs at end of Year 1 = 617700 x (1/0.15) x [1-{1/(1.15)^(9)}] = $ 2947407.39
Option 2: Sale Units = 4300 and Cash Flow per piece = $ 71
Net Cash Flow (NCF) = 71 x 4300 = $ 305300
PV of NCFs at end of Year 1 = 305300 x (1/0.15) x [1-{1/(1.15)^(9)}] = $ 1456764.571
Option 3: Sell the project for a net proceed of $ 1500000
Assuming that each option is equally likely, the probability of each happening would be 1/3
Therefore, Expected PV of Cash Flows at end of Year 1 = (1/3) x 2947407.39 + 1456764.571 x (1/3) + 1500000 = $ 2968057.32
Cash Flow from Sales at end of Year 1 = 71 x 5700 = $ 404700
Total Cash Flow at end of Year 1 = 404700 + 2968057.32 = $ 3372757.32
PV of Total Cash Flow = 3372757.32 / 1.15 = $ 2932832.452
Initial Investment = $ 1680000
NPV = 2932832.452 - 1680000 = $ 1252832.452
(b) If the option to abandon is not available, then there would be only Option 1 and Option 2 available.
Net Cash Flow of Option 1 = $ 2947407.39 and Net Cash Flow of Option 2 = $ 1456764.571
Probability of each option = 0.5
Expected Value of NCF at end of Year 1 = 2947407.39 x 0.5 + 1456764.571 x 0.5 = $ 2202085.98
Cash Flow from Year 1 Sale = $ 404700
Total Cash Flow at end of Year 1 = 2202085.98 + 404700 = $ 2606785.98
PV of Total Cash Flow at the end of Year 0 = 2606785.98 / 1.15 = $ 2266770.42
Initial Investment = $ 1680000
Project NPV = 2266770.42 - 1680000 = $ 586770.42
Option Value = Project NPV with option (from part a) - Project NPV with option (from part b) = 1252832.45 - 586770.42 = $ 666062.03
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.