A firm is considering a project with a 5-year life and an initial cost of $135,0

Question

A firm is considering a project with a 5-year life and an initial cost of $135,000. The discount rate for the project is 13%. The firm expects to sell 2,400 units a year for the first 3 years. The cash flow per unit is $20. Beyond year 3, there is a 40% chance that sales will fall to 1,200 units a year for both years 4 and 5, and a 60% chance that sales will rise to 2,600 units a year, for both years 4 and 5. The firm will have the option to abandon the project after 3 years (i.e., at t=3) by selling it for $60,000 (aftertaxes). You will know which state will be realized in years 4 and 5 (should the project be continued) by the time you have to make the potential abandonment decision at t=3. What is the net present value of this project given the sales forecasts and the abandonment option?

Explanation / Answer

Net present value of given sales forecast

(A) Without abandon

Year

Particulars

Cash flows

PVF @13%

Present value

0

Initial investment

-135000

1

-135000.00

1

Cash inflow (2400*20)

48000

0.884955752

42477.88

2

Cash inflow (2400*20)

48000

0.783146683

37591.04

3

Cash inflow (2400*20)

48000

0.693050162

33266.41

4

Cash inflow (2400*20)

40800

0.613318728

25023.40

5

Cash inflow (2400*20)

40800

0.542759936

22144.61

Total

25503.33

*Year 4 and 5 year cash flow

= (1200*20*0.40)+(2600*20*0.60)

= 40800

Net present value of given sales forecast

(B) With abandon

Year

Particulars

Cash flows

PVF @13%

Present value

0

Initial investment

-135000

1

-135000.00

1

Cash inflow (2400*20)

48000

0.884955752

42477.88

2

Cash inflow (2400*20)

48000

0.783146683

37591.04

3

Cash inflow (2400*20)

48000

0.693050162

33266.41

Salvage value

60000

0.693050162

41583.01

Total

19918.33

Answer: A firm should continue operation for 2 years further as it’s NPV is more as compare to abandon project at year 3.

Net present value of given sales forecast

(A) Without abandon

Year

Particulars

Cash flows

PVF @13%

Present value

0

Initial investment

-135000

1

-135000.00

1

Cash inflow (2400*20)

48000

0.884955752

42477.88

2

Cash inflow (2400*20)

48000

0.783146683

37591.04

3

Cash inflow (2400*20)

48000

0.693050162

33266.41

4

Cash inflow (2400*20)

40800

0.613318728

25023.40

5

Cash inflow (2400*20)

40800

0.542759936

22144.61

Total

25503.33

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