8. ACME has hired you to study the feasibility of a new toy that requires a $5 m

Question

8. ACME has hired you to study the feasibility of a new toy that requires a $5 million initial investment. ACME expects annual cash flows of $880,000 for the next 10 years. The discount rate is 10%. a. What is the NPV of the new toy? b. After one year, the estimate of remaining cash flows will be revised either upward to $1.75 million or downward to $290,000. Each revision has an equal probability of occurring. At that time, the toy project can be sold for $1,300,000. What is the revised NPV given that the firm can abandon the project after one year?

Explanation / Answer

a) 0 -5000000 1 -5000000 1 880000 0.9091 800000      2 880000 0.8264 727272.73 3 880000 0.7513 661157.02 4 880000 0.6830 601051.84 5 880000 0.6209 546410.76 6 880000 0.5645 496737.06 7 880000 0.5132 451579.14 8 880000 0.4665 410526.49 9 880000 0.4241 373205.90 10 880000 0.3855 339278.09 5407219.053 NPV = 407219 b) Upward 1 1750000 0.9091 1590925 2 1750000 0.8265 1446295.45 3 1750000 0.7513 1314814.05 4 1750000 0.6830 1195285.50 5 1750000 0.6209 1086623.18 6 1750000 0.5645 987839.26 7 1750000 0.5132 898035.69 8 1750000 0.4665 816396.08 9 1750000 0.4241 742178.25 NPV= 10078392.46 Downward 1 290000 0.9091 263639.00 2 290000 0.8265 239671.82 3 290000 0.7513 217883.47 4 290000 0.6830 198075.88 5 290000 0.6209 180068.98 6 290000 0.5645 163699.08 7 290000 0.5132 148817.34 8 290000 0.4665 135288.49 9 290000 0.4241 122989.54 NPV= 1670133.61 simple average = 10078392.46 + 1670133.61 /2 5874263 sale price for toy project =                                                             1300000.00 Revised project = 5874263.035-1300000 4574263.035

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