Question

Hightech Plc is considering whether or not to go ahead with the production of an innovative product. The project (called ‘Project A’) requires an initial investment (at time 0) of £10 million, while the company expects the future cash flows to depend on market demand. If demand is high, starting from next year (time 1) the project will produce a perpetual cash flow of £800,000. In case of low demand, the perpetual cash flow will amount to just £300,000. The two scenarios of high and low demand are equally likely (50% probability for each scenario). The project’s cost of capital is 8%. Should Hightech Plc accept Project A today?

Hightech Plc is considering an alternative strategy (‘Project B’). The company could alternatively invest the same amount of money today (i.e. £10 million) to purchase less specialised production machines with positive future salvage value. By following this path, the company would essentially gain the option to sell the machines next year (at time 1 and just after receiving the cash flow for time 1) and recover £8 million. Assuming that the perpetual cash flows and the cost of capital are the same as those in part d), should Hightech Plc accept Project B today? What is the value of the real abandonment option embedded in Project B that is not available in case of Project A?

Answer 1

Calculation of NPV from Project “A”:

NPV = PV of Cash Inflow – PV of Cash Outflow (Initial Investment)

= (800000 * 50%) / 8% + (300000 * 50%) / 8% - 10000000

= 5000000 + 1875000 – 10000000

= -3125000

Since NPV is Negative, Hightech Plc will not accept Project A today.

Calculation of NPV from Project “B”:

NPV = PV of Cash Inflow – PV of Cash Outflow (Initial Investment)

Assumption: Company will sell the machinery after 1 year in low Demand Scenario only.

PV of Cash Inflow @ End of Year 1 = (800000 / 8%) *50% + (300000 + 8000000) *50%

= 5000000 + 4150000

= 9150000

NPV @ Year 0: 9150000 / 1.08 – 10000000

= 8472222 – 10000000

= -1527778

Since NPV is Negative, Hightech Plc will not accept Project B today.

Value of the real abandonment option embedded in Project B that is not available in case of Project A:

= NPV of Project B - NPV of Project A

= -1527778 – (-3125000)

= 1597222

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