Question

Please show work for all steps.

Microsoft wants to launch a new smartphone and expects to sell
50,000 units per year at a net cash flow of $35 per unit for the
next 12 years. Microsoft’s discount rate is 15%, and the initial
investment required is $7.00M. (*Hint: You can ignore
taxes.*)

a) The new smartphone project can be abandoned after the first year in case the project is going poorly, and unnecessary project equipment can be sold off for $6.00M. If all future sales starting in year 2 are revised based on the first year’s performance, at what volume of expected annual sales (i.e. number of units) would it make sense to abandon the project?

b) Explain in your own words how the $6.00M abandonment value can be interpreted as the opportunity cost of keeping the smartphone project at the end of year 1.

You now think there is a 50% probability that expected sales starting in year 2 will be revised upward to 70,000 units per year for the rest of the project life. There is also a 50% probability the expected sales starting in year 2 will be revised downward to 25,000 units per year for the rest of the project life.

c) What is the NPV of the project? (*Hint: You can still sell
the equipment at the end of year 1 for $6.00M.*)

d) What is the value of the option to abandon the smartphone project?

Answer #1

Calculaton NPV of the project

NPV = Present value of cash Inflows - Present value of cash outflows

= 50000*35*Present value annuty factor - $ 7 million

= 50000*35*5.4206 - $ 7 million

= 9.48608 - 7

NPV of project = $ 2.48608 million

a) Calculation of expected no of units of sales after 1 year to Abandon project

After 1 year

Present Value of cash inflows = No of Units * 35 * Present value annuity factor for 11 years

= No of Untits *35* 5.2337

= No of Untits * 183.18

plus sale of machinery = $ 6 million

plus first year sale = $ 1.75 million

Out flows After 1 year

= $ 7 *1.15 = $ 8.05 million

$ 8.05 = 6 + 1.75 + (no of units * 183.18)

By solving Above equation we can get no of units 1638

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