A Canadian firm, is evaluating a project in the United States. This project invo

Question

A Canadian firm, is evaluating a project in the United States. This project involves the establishment of a lumber mill in Wisconsin to process Canadian timber. The factory expects to service clients in the construction industry. All cash flow figures are in thousands. Initial Investment. The initial investment is CAD 25,000. The project is over a period of three years. This investment will be depreciated straight line to zero. Operating Results. The firm expects two equally likely scenarios for the first year of operations. Under the favorable scenario, the firm expects to produce and sell 1,200 units of a product. Under the unfavorable scenario, it expects to produce and sell only 600 units. The selling price is expected to be CAD 25; the variable expense is expected to be CAD 10, and fixed costs excluding depreciation are expected to be CAD 3,500. Additional Investment. If the firm encounters the favorable scenario during year 1, it could make an investment of CAD 15,000 to enable it to produce and sell a total of 3,500 units (additional units is 2,300) in the second and third years. The cost parameters remain unchanged with the exception of depreciation. This secondary investment will be depreciated equally in years 2 and 3. If the firm chooses not to make the investment in year 1, the results of year 1 will be repeated during years 2 and 3. Discount Rate and Miscellaneous. Assume a discount rate of 9 percent and zero taxes.

a. Estimate the NPV of the project.

b. Estimate the NPV of the option to expand.

Explanation / Answer

Answer:a NPV of the project:

Favourable scenario:

Unfavourable Scenario:

Answer:b Npv of the option to expand:

Particulars Time P.V.F (9%) Amount P.V Cash outflow Intial investment 0 1 25000 25000 P.V.C.O (A) 25000 Cash inflow 1-3- 2.53129 14500 36703.71 P.V.C.I (B) 36703.71 N.P.V (B-A) 11703.71 Cash inflow Amount Earnings (1200*15) 18000 Less: Fixed cost 3500 Net earnings 14500

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