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

a. initial investment= CAD 25000

Computation of NPV under two scenarios

Present value (unfav)

Cash flow under fav. scenario= sales- variable expenses-fixed cost

                                                 =1200*25 -1200*10-3500=14500

Cash flow under unfav scenario=600*25-600*10-3500=5500

b. NPV of the option to expand

Cash flow(1st yr) = sales- variable expenses-fixed cost=1200*25 -1200*10-3500=14500

cash flow(2nd yr)=sales- variable expenses-fixed cost- additional investment

                                        =3500*25-1200*10-3500-15000=57000

Cash flow(3rd yr)= 3500*25-1200*10-3500= 72000

Note:- cash flow does not include depreciation since it is non cash item

Year cash flow (fav.) cash (unfav) Discount factor 9% Present value(fav)

Present value (unfav)

0 -25000 -25000 1 -25000 -25000 1 14500 5500 0.917 13296.5 5043.5 2 14500 5500 0.842 12209 4631 3 14500 5500 0.772 11194 4246 NPV 11699.5 -11079.5

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