2.99
See Answer

In Problem 15, 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 is a success. This implies that if the project is a success, projected sales after expansion will be 22,800. Again 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. What is the value of the option to expand?

Problem 15:

In Problem 14, suppose you think it is likely that expected sales will be revised upward to 11,400 units if the first year is a success and revised downward to 3,500 units if the first year is not a success.

a. If success and failure are equally likely, what is the NPV of the project? Consider the possibility of abandonment in answering.

b. What is the value of the option to abandon?

Problem 14:

We are examining a new project. We expect to sell 7,400 units per year at $59 net cash flow apiece for the next 10 years. In other words, the annual cash flow is projected to be $59 × 7,400 = $436,600. The relevant discount rate is 14 percent, and the initial investment required is $1.9 million.

a. What is the base-case NPV?

b. After the first year, the project can be dismantled and sold for $1.1 million. If expected sales are revised based on the first year’s performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project?

c. Explain how the $1.1 million abandonment value can be viewed as the opportunity cost of keeping the project in one year.