Herman Co. is considering a four-year project that will require an initial inves
ID: 2741662 • Letter: H
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 of 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%? $26, 831 $25, 553 $20, 442 $24, 275 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 year 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 it 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. $26, 270 $24, 232 $33, 655 $26, 924 What is the value of the option to abandon the project?Explanation / Answer
Answer 1.
Present Value of Base Case = -12,000 + 15,000*PVIFA(13%, 4)
Present Value of Base Case = $32,617.07
Present Value of Worst Case = -12,000 + -1,500*PVIFA(13%, 4)
Present Value of Worst Case = - $16,461.71
Present Value of Best Case = -12,000 + 22,000*PVIFA(13%, 4)
Present Value of Best Case = $53,438.37
Expected NPV of this project = 32,617.07*50% + (-16,461.71)*25% + 53,438.37*25%
Expected NPV of this project = $25,553
Answer 2.
Present Value of Base Case = -12,000 + 15,000*PVIFA(13%, 4)
Present Value of Base Case = $32,617.07
Present Value of Worst Case = -12,000 + (-1,500)/1.13 + 3,000/1.13^2
Present Value of Worst Case = - $10,977.99
Present Value of Best Case = -12,000 + 22,000*PVIFA(13%, 4)
Present Value of Best Case = $53,438.37
Expected NPV of this project = 32,617.07*50% + (-10,977.99)*25% + 53,438.37*25%
Expected NPV of this project = $26,924
Answer 3.
The value of abandonment is $4,500 (3,000 + 1,500).