Question

8. Abandonment options Shan Co. is considering a four-year project that will require an initial investment of $9,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $21,000 per year, and the worst-case cash flows are projected to be -$2,500 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%? $26,309 $24,994 O $21,047 O $23,678

Answer 1

Expected cash flows Total expected cash flows =cashflows x probability base case best case worst Probability base case best case worst -9000 Present value year (cash flows) base case best case worst pv @ 12% 9000 -9000 -9000 -$9,000 0 1.0 $10,379 $9,267 $8,274 $7,388 7000 1 14000 21000 -2500 0.5 0.25 0.25 5250 -625 11625 0.8929 5250 14000 21000 0.25 7000 0.7972 2 -2500 0.5 0.25 -625 11625 14000 21000 -2500 0.5 0.25 0.25 7000 5250 -625 11625 0.7118 14000 11625 7000 -2500 0.6355 4 21000 0.5 0.25 0.25 5250 -625 $26,309 EXPECTED NPV mintm Expected cash flows Total expected cash flows = cashflows x probability Probability base case best case worst Present value -$9,000 base case best case (cash flows) base case best case worst worst year pv @ 12% -9000 0 -9000 -9000 -9000 1.0 14000 -2500 21000 7000 5250 $10,379 11625 1 0.5 0.25 0.25 -625 0.8929 $10,463 3500 0.7972 2 14000 21000 0.5 0.25 0.25 7000 5250 875 13125 $8,719 14000 21000 5250 7000 12250 0.7118 0 0.5 0.25 0.25 0 $7,785 14000 21000 7000 4 0 0.5 0.25 0.25 5250 0 12250 0.6355 $28,347 EXPECTED NPV $2,038 28347-26309 1 Value of the option to abandon the project