Question
Your company is examining a new project. It expects to sell 9,000 units per year at $35 net cash flow apiece for the next 10
Your company is examining a new project. It expects to sell 9,000 units per year at $35 net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be $35 9,000 = $315,000. The relevant discount rate is 16 percent, and the initial investment required is $1,350,000. (i) What is the base-case NPV? (ii) At the end of the first year, the project can be dismantled and sold for $950,000.
If expected sales are revised based on the first years performance, below what level of expected sales would it make sense to abandon the project? Suppose you think it is likely that expected sales will be revised upward to 11,000 units if the first year is a success and revised downward to 4,000 units if the first year is not a success. (iii) If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering. (iv) What is the value of the option to abandon?
Suppose the scale of the project can be doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would be desirable only if the project were a successthat is, sales were 11,000 units in the first year. This implies that if the project is a success, projected sales after expansion will be 22,000 starting in the second year. (v) Assuming that success and failure are equally likely, what is the NPV of the project? Note that abandonment is still an option if the project is a failure. (vi) What is the value of the option to expand?
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