Herman Co. is considering a four-year project that will require an initial inves
ID: 2746035 • 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 a 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 10%? $30, 822 $28, 020 $23, 817 $29, 421 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, 500 (at the end of year 2). The $3, 500 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. $31, 071 $29, 591 $32, 550 $26, 632Explanation / Answer
a.
Cash Flows = weighted average of probable cash flows = 0.5 x 15000 + 0.25 x 22000 + 0.25 x (-1500) = $12,625
NPV = (NPV(10%, 12625...12625)) - 12000) = $28,020
b
Base $ 15,000 50% Best $ 22,000 25% Worst -$ 1,500 25% Cash Flows $ 12,625 0 1 2 3 4 -$ 12,000 $ 12,625 $ 12,625 $ 12,625 $ 12,625 NPV $ 28,019.55