Question

Shan Co. is considering a four-year project that will require an initial investment of $5,000. The base-case cash flows for this project are projected to be $15,000 per year. The best-case cash flows are projected to be $22,000 per year, and the worst-case cash flows are projected to be - $1,500 per year. The company's analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows. What would be the expected net present value (NPV) of this project if the project's cost of capital is 12%? $30,012 $35,014 $40,016 O $33,347 Shan now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $3,000 (at the end of year 2). The $3,000 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project's assets and the company's -$1,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account. $34,749 $1,402 $45,174 $981 $36,486 $1,122 $1,262 $39,961 $1,472 What is the value of the option to abandon the project?

Answer 1

Expected cash flows Total expected base case best case worst Probability = cashflows x probability cash flows (cash flows) base case best case worst base case best case worst pv @ 12% -5000 -5000 -5000 -5000 1.0 15000 22000 -1500 0.5 0.25 0.25 7500 5500 -375 12625 0.8929 15000 22000 -1500 0.5 0.251 0.25 5500 -375 12625 0.7972 15000 22000 - 1500 0.5 0.25 0.25 7500 5500 -375 12625 0.7118 15000 22000 -1500 0.5 0.25 0.25 7500 5500 -375 12625 0.6355 Present value -$5,000 $11,272 $10,065 $8,986 $8,023 $33,347 EXPECTED NPV 4 Expected cash flows Total expected base case best case worst Probability = cashflows x probability cash flows (cash flows) base case best case worst base case best case worst Ipv @ 12% -5000 -5000 -5000 -5000 1.0 15000 22000 -1500 0.5 0.25 0.25 7500 5500 -375 12625 0.8929 15000 22000 3000 0.25 0.25 7500 5500 750 13750 0.7972 15000 22000 0.5 0.25 0.25 7500 55000 13000 0.7118 15000 22000 0 0.25 0.25 7500 5500 13000 0.6355 Present value $5,000 $11,272 $10,961 $9,253 $8,262 $34,749 EXPECTED NPV 0.5 Value of the option to abandon the project = $1,402 ( 34749-33347]