a. SI is considering investing in a new product named Z90. There is a 50% chance

Question

a. SI is considering investing in a new product named Z90. There is a 50% chance that the product will be a success, which then generates $110,000 cash inflow each year for the next 5 years. There is a 50% chance that the product will fail, which then generates $25,000 cash inflow each year for the next 5 years. The project requires an initial investment of $250,000. Based on the above information, what is the Z90's expected net present value if the cost of capital is 12%? b. Now, assume that one year from now, SI will know if the Z90 has become the industry standard. Assume also that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?

Explanation / Answer

Solution:- NPV of the project= Probability of Success* NPV of present value of cash inflow if successful - Cash outflow

Present value of cash outflow=$250,000
Present value of cash Inflow if Sucessfull = Annaul cash flow*PVAF(r,n)
=110,000*PVAF(12%,5 years) =110,000*3.605 = $396,550
NPV of the project= 50%(396,550 - 250,000) =$73,275

(b) Estimated value of the abandonment

By abandoning project we receive salvage value of $100,000 and 1 year cash flow but give up cash flows for remaining 4 years. Therefore optimal strategy is to abandon the project at the end of the first year if PV of remaining cashflows in 4 years is less than the salvage value .

PV of remaining cashflow in 4 years

value of the abandonmen = salvage value of $100,000 + First year cash flow
=$100,000+110,000 = $210,000

PV of remaining cashflows in 4 years is more than the salvage value therefore it is not suggested to abondoning the project.

year cash inflow PVF@12% PV 2 110,000 0.797 87670 3 110,000 0.712 78320 4 110,000 0.636 69960 5 110,000 0.567 62370 Present value of cash inflow at year 1 $298,320

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