Question
The Masterhausen Group is considering the purchase of a piece of equipment whose upfront cost is 51.40 million. The company estimates that the result of
The Masterhausen Group is considering the purchase of a piece of equipment whose upfront cost is 51.40 million. The company estimates that the result of operating this equipment could go one of two ways: It could be highly successful and produce EBIT of 18 million in year one and that EBIT grows at 4% per year for nine more years; or it could be a poor performance and produce only 5 million in EBIT in year one and that will grow by only 2% per year over the remaining useful life of ten years. The machine will be depreciated on a straight line basis over its useful life down to a book value of 6.4 million. THe expected salvage value of the machine at the end of year ten is 8 million. The company's marginal tax rate is 40% and its WACC is 15 %. The company assigns a 30% chance to sucess.
A. Given the above information and based on static analysis, should the company go ahead with its investment?
B. Upon futher study the company realizes that, if the project proved to be underproforming by the end of year one, the company can stop production and sell the machine for a salvage value of 48 million. Given this information, should the company go ahead with the investment?
C. What is the present value of the option to abandon?
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