Question

A firm is considering a project with a 5-year life and an initial cost of $1,000,000. The discount rate for the project is 9%. The firm expects to sell 2,500 units a year for the first 3 years. The after-tax cash flow per unit is $120. Beyond year 3, there is a 50% chance that sales will fall to 400 units a year for both years 4 and 5, and a 50% chance that sales will continue at 2,500 units a year, for both years 4 and 5. The firm will have the option to abandon the project after 3 years (i.e., at t=3) by selling it for $250,000 (after-taxes). You will know which state will be realized in years 4 and 5 (should the project be continued) by the time you have to make the potential abandonment decision at t=3. What is the net present value of this project given the sales forecasts and the abandonment option? In your answer, show the NPV with the option and without the option.

Answer 1