We are examining a new project. We expect to sell 6,300 units per year at $57 ne

Question

We are examining a new project. We expect to sell 6,300 units per year at $57 net cash flow apiece for the next 10 years. In other words, the annual cash flow is projected to be $57 × 6,300 = $359,100. The relevant discount rate is 12 percent, and the initial investment required is $1,740,000. After the first year, the project can be dismantled and sold for $1,610,000. Suppose you think it is likely that expected sales will be revised upward to 9,300 units if the first year is a success and revised downward to 4,900 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 18,600. 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

Answer: The gain from the option to expand is the present value of the cash flows from the additional units sold, so:

Gain from option to expand = $57(9,300)(PVIFA12%, 9) = $2,824,478.82

We need to find the value of the option to expand times the likelihood of expansion. We also need to find the value of the option to expand today, so:

Option value = (0.50)( $2,824,478.82)/1.12 = $1,260,928

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