Question
We are examining a new project. We expect to sell to sell 7,600 units per year at $68 net cash flow apiece for the next
We are examining a new project. We expect to sell to sell 7,600 units per year at $68 net cash flow apiece for the next ten years. In other words, the annual operating cash flow is projected to be $68 x 7,600 = $516,800. The company uses a 14% discount rate and the initial investment required is $2,300,000.
a. What is the projects base-case NPV? (2 marks)
b. After the first year, the project can be dismantled and sold for $1,400,000. If expected sales are revised based on the first years performance, when would it make sense to abandon the investment? In other words, at what level of expected unit sales would it make sense to abandon the project? (3 marks)
c. Explain how the $1,400,000 abandonment value can be viewed as the opportunity cost of keeping the project in one year. (2 marks)
Suppose that you think it is likely that expected unit sales will be revised upward to 9,000 if the first year is a success and revised downward to 3,500 units if the first year is a flop. Assume both success and failure are both equally likely to occur.
d. If Success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. (4 marks)
e. What is the value of the option to abandon? (2 marks)
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