We are examining a new project. We expect to sell 5,100 units per year at $65 ne

Question

We are examining a new project. We expect to sell 5,100 units per year at $65 net cash flow apiece for the next 10 years. In other words, the annual cash flow is projected to be $65 X 5,100 = $331,500. The relevant discount rate is 15 percent, and the initial investment required is $1,500,000. After the first year, the project cari be dismantled and sold for $1,220,000. Suppose you think it is likely that expected sales will be revised upward to 8,100 units if the first year is a success and revised downward to 3,700 units if the first year is not a success. Suppose the scale of the project can be doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would only be desirable if the project were a success. This implies that if the project is a success, projected sales after expansion will be 16,200. Note that abandonment is an option if the project is a failure. If success and failure are equally likely, what is the NPV of the project?

Explanation / Answer

Cash inflows Probability Expected Year Success Faillure Success Faillure Sales 1 331500 331500 0.5 0.5 331500 2 526500 240500 0.5 0.5 383500 3 526500 240500 0.5 0.5 383500 4 526500 240500 0.5 0.5 383500 5 526500 240500 0.5 0.5 383500 6 526500 240500 0.5 0.5 383500 7 526500 240500 0.5 0.5 383500 8 526500 240500 0.5 0.5 383500 9 526500 240500 0.5 0.5 383500 10 526500 240500 0.5 0.5 383500 total Expected Value of Sales = Sales in Success x 0.5 +Sales in faillure x 0.50 PV Factor Present Year Cashflow at 15% Value 0 -1500000 1 -1500000 1 331500 0.869565 288260.9 2 383500 0.756144 289981.1 3 383500 0.657516 252157.5 4 383500 0.571753 219267.4 5 383500 0.497177 190667.3 6 383500 0.432328 165797.6 7 383500 0.375937 144171.9 8 383500 0.326902 125366.8 9 383500 0.284262 109014.6 10 383500 0.247185 94795.33 Total 2283000 379480.4 Answer: NPV = $379,480.40

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