Options to Abandon and Expand Grace and Danger plc is introducing a new product this year. If its luminous golf balls (with integrated beeper) are a success, the firm expects to be able to sell 50,000 units a year at a price of £60 each (they will not go missing so you will pay a lot for them!). If the new golf balls are not well received, only 30,000 units can be sold at a price of £55. The variable cost of each golf ball is £30 and the fixed costs are zero. The cost of the manufacturing equipment is £6 million, and the project life is estimated to be 10 years. The firm will use 20 per cent reducing balances as its method of depreciation and at the end of the project’s life, the machine will be worth nothing. Grace and Danger’s tax rate is 28 per cent and the appropriate discount rate is 12 per cent.

(a) If each outcome is equally likely, what is the expected NPV? Will the firm accept the project?

(b) Suppose now that the firm can abandon the project and sell off the manufacturing equipment for

£5.4 million if demand for the golf balls turns out to be weak. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm’s decision to accept the project?

(c) Now suppose Grace and Danger can expand production if the project is successful. By paying its workers overtime, it can increase production by 25,000 golf balls; the variable cost of each ball will be higher, however: equal to £35 per golf ball. By how much does this option to expand production increase the NPV of the project?