Reference no: EM132785222

You are evaluating a new project. The expected sales from the project are 7,000 units per year at $38 net cash flow per unit for the next 10 years. In other words, the annual operating cash flow is projected to be $38×7,000=$266,000. The relevant discount rate is 16 percent, and the initial investment required is $1,040,000. After the first year, the project can be dismantled and sold for $820,000. After the first year, expected sales for the remaining 9 years are revised based on the first year's performance. Suppose you think it is likely that expected sales will be revised upward to 9,500 units if the first year is a success and revised downward to 3,800 units if the first year is a failure.

Required:

(a) At what level of expected sales would it make sense to abandon the project?

(b) Calculate the value of the option to abandon the project, if it is equally likely that the first year will be either a success or a failure.

(c) Suppose the scale of the project can be doubled in one year in the sense that twice as many units can be produced and sold. Naturally, expansion would be desirable only if the project were a success. This implies that if the project is a success, projected sales after expansion will be 19,000. Again assuming that success and failure are equally likely, what is the NPV of the project (at time zero)? Note that abandonment is still an option if the project is a failure.

(d) Calculate the value of the option to expand.