4. A local firm is considering a project with the following cash flows: Predicte

Question

4. A local firm is considering a project with the following cash flows: Predicted Cash Flows 0 1 2 3 Best Case(p=.25) -25,000 18,000 18,000 18,000 Base Case(p=.50) -25,000 12,000 12,000 12,000 Worst Case(p=.25) -25,000 -8000 -8000 -8000 a. Using the cash flows on the table above, find the project’s expected NPV, assuming the required return is 12%. b. Assume that the company can sell the project for $15,000 at the end of year 2. Assume that the required return is still 12%. What is the new value of the project? c. What is the value of the abandonment option?

Explanation / Answer

Expected cash flows = Probability * cash inflows

= 18,000 * 0.25 + 12,000* 0.50 + (8,000) * 0.25

= 4,500 + 6,000 + (2,000)

= 8,500

Initial investment = 25,000

NPV = PV of cash inflows - PV of cash outflows

= 8,500 * PVAF(12%, 3 yrs) - 25,000

= (8500 * 2.402- ) 25,000

= - 4,585 (approximtely)

If the company can sell the project at the end of year 2

NPV

= 8500 * PVAF(12%, 2 yrs) + 15,000 * PVIF(12%,2nd yr) - 25,000

= (8,500 * 1.690) + (15,000 * 0.797) - 25,000

= 14,365 + 11,955 - 25,000

= 1320

Therefore value of abandonement option = 1320 - (-4585) = 5,905

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