Allied Products, Inc., is considering a new product launch. The firm expects to

Question

Allied Products, Inc., is considering a new product launch. The firm expects to have annual operating cash flow of $9.2 million for the next 8 years. Allied Products uses a discount rate of 13 percent for new product launches. The initial investment is $39.2 million. Assume that the project has no salvage value at the end of its economic life.

a. What is the NPV of the new product? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Round your answer to 2 decimal places, e.g., 32.16.)

NPV $

b. After the first year, the project can be dismantled and sold for $26.2 million. If the estimates of remaining cash flows are revised based on the first year’s experience, at what level of expected cash flows does it make sense to abandon the project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Round your answer to 2 decimal places, e.g., 32.16.)

Annual cash flows $

Explanation / Answer

a)Initial Investment = -$39,200,000

Annual Cash Flow =$9,200,000

The cash flows from this project are an annuity, so the NPV is :

NPV = -$39,200,000 + $9,200,000(PVAF 13%,8)

           = -$39,200,000 + $44,148,960

         = $49,48,960

b) Scrap Value = $ 26,200,000

If the Present value of the revised cash flows for the next 7 years is less than the project’s scrap value then Allied Products should abandon the project. Since the option to abandon the project occurs in 1 year discount the revised cash flows to year 1 as well. To determine the level of expected cash flows below which Allied Products should abandon the project, calculate the equivalent annual cash flows the project must earn to equal the scrap value which is $26,200,000 million. Set the scrap value equal to 7 year annuity, discounted at 13%.

Solve the cash flows (C1):

Scrap Value = C1 ATr

Where T = no. of years

               r = discount rate

$ 26,200,000 = C1 A70.13

$ 26,200,000 / A70.13 = C1

C1 = $ 26,200,000 /4.4226 = $5,924,117.035

The firm should abandon the project after the first year if the revised expected annual cash flows are below $5,924,117.035. Below that level the firm is better off abandoning the project and receiving the $26,200,000 million scrap value of the project.

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