Your firm is considering a project with a five-year life and an initial cost of

Question

Your firm is considering a project with a five-year life and an initial cost of $120,000. The discount rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow per unit is $20. The firm will have the option to abandon this project after three years at which time it expects it could sell the project for $50,000. You are interested in knowing how the project will perform if the sales forecasts for years four and five of the project are revised such that there is a 50% chance that the sales will be either 1,400 or 2,500 units a year. What is the net present value of this project given your sales forecasts?

Explanation / Answer

depriciation per year = 14000

cash flow for years 1-3

= 2100 * 20 -14000 = 42000 - 14000 = 28000

expected slaes in 4 and 5 = 0.5 * 1400 + 0.5 * 2500 = 1950

cash flow for years 4 and 5 = 1950 * 20 - 14000 = 25000

terminal cash flow = 50000

NPV = -120000 + 28000/1.12 + 28000/1.12^2 + 28000/1.12^3 + 25000/1.12^4 + 75000/1.12^5

=5696.24

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