Question

1. Johnson fert and Dog supllies is considering a new project for mobile pet grooming and garden supply sales. The project requires a $10 million expenditure in year 0. The expected cash flows from the project maybe $20 with a probability of 40% or $5 million with a probability of 60%.   Thomas' WACC=16% and this project is of similar risk to the rest of Johnsons' business projects. Find the NPV of the project.
2. If Johnson enters into the project above, it can sell the product in one year for $6 million. Find the NPV of the project with the abandonment option.

Answer 1

i). Solution :- Net present value (NPV) of project = Present value of cash inflows - Present value of cash outflow.

Future value of cash inflows = 20 Million * 0.40 + 5 Million * 0.60

= 8 Million + 3 Million

= $ 11 Million.

Present value of cash inflows = 11 Million / 0.16

= $ 68.75 Million.  

Accordingly, Net present value (NPV) of project = 68.75 million - 11 Million

= $ 57.75 Million.

Conclusion :- Net present value (NPV) of project = $ 57.75 Million (approx).

NPV is calculated assuming that cash inflows from project continues forever as it is not mentioned in question regarding for the number of years cash inflows generated from project.

ii). Solution :- NPV of project = (11 Million + 6 Million) / (1 + 0.16)¹ - 10 Million.

= 17 Million / (1.16)¹ - 10 Million

= 14.66 Million - 10 Million

= $ 4.66 Million.

Conclusion :- NPV of project (abandonment option) = $ 4.66 Million.