Question

Apple is considering a project with a three-year life and an initial cost of $90,000. The discount rate for the project is 16 percent. The firm expects to sell 1,400 units on the last day of each year. The cash flow per unit is $35. The firm will have the option to abandon this project following the sales on the last day of year 2 at which time the project's assets could be sold for an estimated $45,000. The firm's managers are interested in knowing how the project will perform if the sales forecast for year 3 of the project is revised such that there is a 50/50 chance that the sales will be either 1,200 or 1,600 units a year. What is the net present value of this project at Time 0 given the current sales forecasts?

Please help me. Thank you!!

Answer 1

let 'x' be abandon level units

so,

45,000 = 35*x / 1.16

so x = 1491.43

when sales are below 1491.3(i.e., at 1200) we will abandon project and receive 45000

when sales are above 1491.1 (i.e.,at 1600) we will continue.

NPV at end of year 2 = (1600*35) / 1.16

= 48,275.86

it is given probability of occurance = 50 : 50

so NPV at end of year 2 = (0.5*45000) + (0.5*48275.86)

= 46637.93

NPV at (t = 0) is = -90,000 + (1400*35) / 1.16 + (1400*35) / 1.16^2 + (46637.93) / 1.16^2

= $23,315.94 (rounded to two decimals). (in case of nearest whole number = $23,316)