I need to see how it is worked out. SI is considering investing in a new product
ID: 2753456 • Letter: I
Question
I need to see how it is worked out.
SI is considering investing in a new product named Z90. There is a 50% chance that the product will be a success, which then generates $110,000 cash inflow each year for the next 5 years. There is a 50% chance that the product will fail, which then generates $25,000 cash inflow each year for the next 5 years. The project requires an initial investment of $250,000. Based on the above information, what is the Z90's expected net present value if the cost of capital is 12%?
Now, assume that one year from now, SI will know if the Z90 has become the industry standard. Assume also that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?
Explanation / Answer
1)
Expected Cash Flow = 110000*50% + 25000*50%
Expected Cash Flow = 67500
Z90's expected net present value = - initial investment + Expected Cash Flow*(1-(1+r)^-n)/r
Z90's expected net present value = -250000+ 67500*(1-(1+12%)^-5)/12%
Z90's expected net present value = -6677.61
2)
Scenario 1) : 110000 cash inflow
PV of remaining 4 year Cash Flow = 110000*(1-(1+12.5%)^-4)/12.5%
PV of remaining 4 year Cash Flow = $ 330,620.33
Payoff = Nil
Scenario 2) : 25000 cash inflow
PV of remaining 4 year Cash Flow = 25000*(1-(1+12.5%)^-4)/12.5%
PV of remaining 4 year Cash Flow = $ 75,140.98
Payoff = 100000 - 75140.98
Payoff = $ 25859
Expected Payoff = 50%*0 + 50%*25859
Expected Payoff = $ 12,930
Estimated value of the abandonment option = Expected Payoff / (1+r)
Estimated value of the abandonment option = 12930/1.12
Estimated value of the abandonment option = $ 11,544.64
Note :
NPV after considering abandonment option = - 6677.61 + 11544.64
NPV after considering abandonment option = $ 4867.03