Acme Co. is considering a four-year project that will require an initial investm

Question

Acme Co. is considering a four-year project that will require an initial investment of $15,000. The base-case cash flows for this project are projected to be $15,000 per year. The best-case cash flows are projected to be $22,000 per year, and the worst-case cash flows are projected to be -$1,500 per year. The company's analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows. What would be the expected net present value (NPV) of this project if the project's cost of capital is 12%? O $19,845 O $28,016 O $26,849 O $23,34;7 Acme now wants to take into account its abilty to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,500 (at the end of year 2). The $4,500 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project's assets and the company's-$1,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account. O $28,80s O $30,058 O $27,553 O $25,0418 What is the value of the option to abandon the project?

Explanation / Answer

Soln : 1) Initial Investment = $15000, Base case cash flows = $15000 per year, Best case cash flows = $22000 per year

worst case cash flows = -$1500 per year, project cost of capital = 12%

NPV of project = -15000 + 50%*15000/(1+r) + 25%*(22000-1500)/(1+r) + 50%*15000/(1+r)2 + 25%*(22000-1500)/(1+r)2 + 50%*15000/(1+r)3 + 25%*(22000-1500)/(1+r)3 + 50%* 15000/(1+r)4 + 25%*(22000-1500)/(1+r)4

NPV = -15000 + 38346.54 = 23346.53

Ans is d) $23347

2) Now, as it is considered the project will be closed after 2 years and only worst cash flows are coming

In that case the NPV = -15000

50%*15000/(1+r) + 25%*(22000-1500)/(1+r) + 50%*15000/(1+r)2 + 25%*(22000+4500)/(1+r)2 + 50%*15000/(1+r)3 + 25%*(22000)/(1+r)3 + 50%* 15000/(1+r)4 + 25%*(22000)/(1+r)4

NPV = -15000 + 40047.56 = 25047.56

Ans: d) that is $25048

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