Herman CO, is considering a four-year project that will require an initial inves

Question

Herman CO, is considering a four-year project that will require an initial investment of $12, 000. The base-case cash flows for this project are projected to be $15, 000 per year. The best-case cash flows are projected to be $22, 000 per year, and the worst-case cash flows are projected to be-$1, 500 per year. The company's analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability to the project generating the best-case cash flows. and a 25% probability of the project generating the worst-case cash flows. What would be the expected net present value (NPV) of this project If the project's cost of capital is 13%? Herman now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $3, 000 (at the end of year 2). The $3, 000 the company receives at the end of yea' 2 is the difference between the cash the company receives from selling off the project's assets and the company's -$1, 500 cash outflow from operations. Additionally, if abandons the project, the company will have no cash flows in years 3 and 4 of the project. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account. What is the value of the option to abandon the project

Explanation / Answer

Cash Outflow $12000 Present value factor (year 0, 13%) 1 Present value of cash outflow = $12000 CASE Cash flow (A) Probability (B) (A) * (B) Base case 15000 50% 7500 Best case 22000 25% 5500 Worst case -1500 25% -375 Total cash Inflow 12625 Present value factor (year 1-4, 13%) 2.9745 Present value of cash Inflow 37553 NPV = Present value of cash Inflow - Present value of cash outflow NPV = 37553 - 12000 25553

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