Question

Western Industrial Products is considering a project with a five-year life and an initial cost of $300,000. The discount rate for the project is 11 percent. The firm expects to sell 2,600 units a year. The cash flow per unit is $30. The firm will have the option to abandon this project at the end of year three (after year three's sales) at which time the project's assets could be sold for an estimated $55,000. The firm should abandon the project at the end of year three if the expected level of annual sales, starting with year 4, falls to _____ units or less. Ignore taxes.

	867 units
	111 units
	1,071 units
	2,259 units
	1,300 units

Answer 1

Solution:

In simplest of words, if the present value of cash flow from the sales of year 4 and year 5 are more than the present value of $55,000 than the project should be abandoned and vice-versa.

Let the required number of units be X units. Thus, the cash flow from year 4 and year 5 becomes $30X each. At the level of X units, the sum of present values of these two yearly cash flows will be equal to the present value of $55,000.

$55,000*(1/1.11)³ = $30X*(1/1.11)⁴ + $30X*(1/1.11)⁵

$55,000*0.731= $30X*(0.659+0.593)

X= 1071 units

Thus, at 1,071 units or less the project should be abandoned. The correct option is the third option.