Question

As part of its plan to diversify the business lines, HHB has recently embarked in a project to acquire a start-up enterprise specialising in bottled water manufacturing. It is expected that the enterprise is able to sell 4 million bottles per year at a net cash flow of $0.50 per bottle for the next five years. However, due to increased competition and unpredictable change in government regulations, demand for the product will be highly uncertain. They will learn if the product is a success or failure at the end of the first year after the acquisition. Their market intelligence report has shown that if it is a success, unit sales will be 7 million bottles per year. If it is a failure, unit sales will be 1 million. Success and failure are equally likely. The relevant discount rate is 15% and capital investment on the acquisition is $7 million. If HHB were to divest the start-up enterprise after year 1 (option to abandon), they can receive back a value of $4 million.

Estimate the Net Present Value (NPV) of the project with the option to abandon.

Answer 1

answer

value( in millions)	year 0	year 1	year2	year3	year 4	year 5
Capital investment	-7
Unit sales revenue		1	0	0	0	0
proceeds from divest		4
	-7	5	0	0	0	0
ROR	15.0%
NPV	$ -2.31

iIf the project is to be abandon company will incur a loss of $2.31 million