Question

High Roller Properties is considering building a new casino at a cost of $10 million at t = 0. The after-tax cash flows the casino generates will depend on whether the state imposes a new income tax, and there is a 50-50 chance the tax will pass. If it passes, after-tax cash flows will be $1.875 million per year for the next 5 years. If it doesn't pass, the after-tax cash flows will be $3.75 million per year for the next 5 years. The project's WACC is 11.0%. If the tax is passed, the firm will have the option to abandon the project 1 year from now, in which case the property could be sold to net $6.5 million after tax at t = 1. What is the value (in thousands) of this abandonment

Answer 1

WACC = 11%

Investment cost = $ 10,000

Cash flow with no tax = $ 3,750

Cash flow with tax = $ 1,875

Salvage value = $ 6,500

Computation of the expected NPV without abandonment.We have,

Particulars	Prob.	0	1	2	3	4	5	NPV
No tax	0.50	- 10,000	3,750	3,750	3,750	3,750	3,750
PFIF@11%		1.00	0.901	0.812	0.731	0.659	0.593
Present value		-10,000	3,378.75	3045	2741.25	2,471.25	2,223.75	3,860
New tax	0.50	- 10,000	1,875	1,875	1,875	1,875	1,875
PVIF@11%		1.00	0.901	0.812	0.731	0.659	0.593
Present value		-10,000	1,689.38	1,522.50	1,370.62	1,235.63	1,111.88	-3070
Expected NPV								395

Computation of the expected NPV with abandonment.We have,

Particulars	Prob.	0	1	2	3	4	5	NPV
No tax	0.50	- 10,000	3,750	3,750	3,750	3,750	3,750
PFIF@11%		1.00	0.901	0.812	0.731	0.659	0.593
Present value		-10,000	3,378.75	3045	2741.25	2,471.25	2,223.75	3,860
New tax	0.50	- 10,000	1,875
Salvage value			6,500
PVIF@11%		1.00	0.901
Present value		-10,000	7,546					- 2,454
Expected NPV								703

The value of option to abandonment(in thousands)= 703 - 395 = $ 308