Question
Atlantic Tires is considering an investment in a new production facility. For the next five years, the company expects to achieve an annual cash flow
Atlantic Tires is considering an investment in a new production facility. For the next five years, the company expects to achieve an annual cash flow of $400,000 if the project is fully successful, $200,000 if the project is partially successful, and $100,000 if the project is a failure. The probability of full success is 30%, partial success is 50%, and failure is 20%. The initial investment required is $1,000,000, and the relevant discount rate is 10%. Assume the production facility will be obsolete five years from now.
a. What is the base-case NPV? (3 marks)
b. Suppose the company has an option to double the scale of the project in one year if the project is a full success at the end of the first year. This would imply that if the project is fully successful, the annual cash flow would be $800,000 per year after expansion (i.e., starting in year 2). No additional investment is required for expanding the project. In addition, based on the first year's performance, the project can be abandoned and sold for $500,000 at the end of the first year. Under which scenario(s) the project should be abandoned? (5 marks) What is the NPV of the project? Consider the possibility of both expansion and abandonment in answering. Note: do not compute the option values in answering. (5 marks)
c. What is the value of the option to expand? (3 marks)
d. What is the value of the option to abandon? Use two different ways to answer this question. (6 marks)
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