Carlson Inc. is evaluating a project in India that would require a $6.2 million
ID: 2644463 • Letter: C
Question
Carlson Inc. is evaluating a project in India that would require a $6.2 million investment today (t = 0). The after-tax cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12.0%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the value (in thousands) of this abandonment option?
a)104
b)115
c)128
d)141
e)155
Explanation / Answer
To calculate the value of the abondonment option, we need to calculate the difference the NPV of cash flows without tax and NPV of abandonment.
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Step 1: Calculate NPV of Cash Flows Without Tax
NPV is the difference between the present value of costs and present value of benefits expected from the project. Present value is calculated by discounting the cash flows expected from the project. The general formula for calculating NPV is:
NPV = -Initial Investment + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 2/(1+Discount Rate)^2 + Cash Flow Year 2/(1+Discount Rate)^3 + Cash Flow Year 4/(1+Discount Rate)^4 + Cash Flow Year 5/(1+Discount Rate)^5
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Using the above formula and values provided in the question, we get,
Cash flows have been adjusted for $1,000
NPV (Without Tax Cash Flows) = -6,200+2,000/(1+0.12)^1+2,000/(1+0.12)^2+2,000/(1+0.12)^3+2,000/(1+0.12)^4+2,000/(1+0.12)^5 = $1,009.55
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Step 2: Calculate NPV of the Abandonment
Here, the project will produce a cash inflow of $1,350,000 (or $1,350) and $4,750,000 (or $4,750) at the end of Year 1. These cash inflows will be discounted to today's value against the initial investment of $6,200,000 ($6,200) to calculate the NPV.
NPV (Abandonment) = -6,200 + (1,350 + 4,750)/(1+12%)^1 = -$753.57
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Step 3: Calculate Final NPV
Since, the possibility of passing tax is 50%, we will take only 50% NPV of the abandonment value calculated in step 2.
Final NPV = NPV (Without Tax Cash Flows) + NPV (Abandonment)*50% = $1,009.55 + (- 753.57*50%) = $128 (which is Option C)