Real Options—the Option to Abandon a Project You and several of your classmates have just...

Real Options—the Option to Abandon a Project You and several of your classmates have just graduated from college and are evaluating various investment opportunities, including a start-up company that would produce high-quality jackets embroidered with a college logo. If demand for this customized product is high, you expect to sell approximately 100,000 units per year, at a price per unit of $80. On the other hand, because of stiff competition in the field, a pessimistic estimate is that demand for your new product would be only 40,000 units per year at a selling price of $70. Anticipated variable costs per jacket amount to $40. Capacity-related (i.e., short-term fixed) costs other than the cost of manufacturing equipment are thought to be negligible. Manufacturing equipment (with a 10-year life, a cost of $12 million, and a zero salvage value) would have to be purchased as part of this project. Assume that for income-tax purposes your company will use straight-line depreciation over the life of the proposed investment. Your anticipated income-tax bracket for this endeavor is 33 1/3 percent. You are unsure of what discount rate to use for capital-budgeting purposes, but you believe the appropriate rate is somewhere between 10 percent and 14 percent on an after-tax basis.

Required

1. What is the anticipated after-tax cash flow for this investment for each of the two possible states of nature/scenarios?

2. Under the assumption that the two scenarios (level of product demand) are equally likely, what is the expected NPV of the proposed investment? Assume a discount rate of 12 percent. Based on the amount you estimated, should you invest in the project?

3. How sensitive is your decision to the assumption regarding the discount rate? To answer this question, prepare an estimated NPV for the proposed project using discount rates, in 1 percent increments, from 10 percent to 14 percent. Is the decision to accept or reject the investment sensitive to the discount rate used in the calculation of NPV?

4. Suppose your company could abandon the project and dispose of the manufacturing equipment for $10.4 million if demand for your product turns out to be weak. You and your colleagues would make this decision at the end of the first year of operations. Does the abandonment option change your decision as to whether to invest in the project? (Use a discount rate of 12%.)