Broadway Inc. is considering a new musical. The initial investment required is $

Question

Broadway Inc. is considering a new musical. The initial investment required is $880,000. Every year, the free cash flow from the project is expected to be $80,000, continuing forever.

a. What is the NPV of the project?

b. In fact, the annual cash flow of $80,000 is an expected value: there is a 50% chance that annual cash flow will be $180,000 and a 50% chance that it will be -$20,000. What is the expectedNPV of the project if the company cannot abandon the project?

c. What is the true NPV of the project if the company can abandon the project after thefirst year?

d. What is the value of the option to abandon?

Explanation / Answer

a. Let the interest rate be 10% then the NPV of the project is caluculated as follows

NPV = (80000/0.1) - 880000 = 800000 - 880000 = (-) 80000

b. Now as the expected annual cash flow of the project = 0.5 * 180000 + 0.5 * (-) 20000 = 90000 - 10000 = 80000

Therefore expected NPV = (80000/0.1) - 880000 = 800000 - 880000 = (-) 80000

c. NPV of the project if company abondon the project after first year = (80000/1.1) - 880000 = 72727.27 - 880000 = (-) 807272.73

d. If a company wants to abondon the project then NPV can be calculated as

NPV = {80000/(1+R)^T} - 880000

where R is the rate of interes and T is the time after which a company wants to abondon its operations.

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