Question 1 A project has a cost of R1.4 million and next year will generate eith

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Question 1

A project has a cost of R1.4 million and next year will generate either R2 million or R100,000 with equal probability. Assuming an 8 percent discount rate, what is the NPV of the project based on the expected cash flows next year? If the company could pay R50,000 today for an exclusive right to manufacture the project, this would allow the company to make the R1.4 million investment under conditions of generating R2 million in cash flow, and not manufacture the project under the R100,000 cash flow scenario. Assess the NPV of this exclusive right to manufacture (a type of abandonment option allowing the company to not manufacture under poor conditions) by calculating the profit under both cash flow scenarios:
1.1. R2 million less R1.4 million for the R2 million scenario. (5)
1.2. Zero for the R100,000 cash flow scenario (Note: there is an assumption that the company can manufacture the product immediately and that manufacturing costs do not increase, which may not be realistic). (5)
1.3. Should the company pay R50,000 for the exclusive right to manufacture

Explanation / Answer

Profit/NPV if company Generate R 2 million cash Flow next year :-

a. Cost of Project = R 14,00,000

b. Present Value of Cash Flow = R 20,00,000 * 1/1.08 = R 18,51,852

c NPV/Profit = b-a

= 18,51,852-14,00,000

NPV = R 4,51,852

Profit/NPV if company Generate R 100000 only cash Flow next year :-

a. Cost of Project = R 14,00,000

b. Present Value of Cash Flow = R 1,00,000 * 1/1.08 = R 92,593

c NPV/Profit = b-a = R (13,07,507)

Profit/NPV if company does not invest for Exclusive Right:-

Profit/NPV if company invest R 50,000 in Exclusive Rights :-

If CF= R1.4 Million then NPV would be R 4,51,852-50,000 = 4,01,852

However if CF = R 100000 then NPV would be Zero (0) as the company will not be invest in project and expesne of R 50,000 being Sunk Cost will be ignored.

Hence the NPV of Project if Invesrment is made in Exclusive Right will be

Since there is Positive as well as higher NPV if Company invest in Exclusive right of project it is advisable for the company to invest in project along with investing for exclusive right of the product.

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Scnario NPV Probability (P) NPV * P a. CF = R2M 4,51,852 0.50 2,25,926 b CF = R100000 (13,07,507) 0.50 (6,53,754) Expected NPV (6,53,754)

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