We are examining a new project. Suppose we think it is likely that expected sale
ID: 2777516 • Letter: W
Question
We are examining a new project. Suppose we think it is likely that expected sales will be either 9,500 units if the project is a success or revised downward to 3,000 units if the project is not a success. We expect $63 net cash flow APIECE for the next 10 years. The relevant discount rate is 14 percent, and the initial investment required is $1,600,000. At the end of the first year, the project can be dismantled and sold for $1,200,000 a.) If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. b.) What is the value option to abandon?
Explanation / Answer
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Discounting rate @14% 1 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 Scenario of Success Investment (1,600,000) Cash Flow 598,500 598,500 598,500 598,500 598,500 598,500 598,500 598,500 598,500 598,500 PV of Cash Flow 3,121,845 525,000 460,526 403,970 354,360 310,842 272,669 239,183 209,810 184,044 161,442 NPV 1,521,845 Scenario of Failure with Abandonment Investment (1,600,000) Cash Flow 189,000 Salvage value 1,200,000 Total Inflow 1,389,000 PV of inflow 1,218,421 NPV (381,579) In case of equal probability the net NPV of the project will be = 0.50*1521845+0.50*(-381579) = 570,133 Ans a So net NPV is &570,133 Scenario of Failure without Abandonment Investment (1,600,000) Cash Flow 189,000 189,000 189,000 189,000 189,000 189,000 189,000 189,000 189,000 189,000 PV of inflow 985,846 165,789 145,429 127,570 111,903 98,161 86,106 75,531 66,256 58,119 50,982 NPV (614,154) NPV of Failure scenario with Abandonment (381,579) Ans b. Value option to abandon 232,575
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