Question

Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. It is considering the introduction of a “weight loss” smoothie. The project would require a $5 million investment outlay today (t = 0). The after-tax cash flows would depend on whether the weight loss smoothie is well received by consumers. There is a 30% chance that demand will be good, in which case the project will produce after-tax cash flows of $1 million at the end of each of the next 3 years. There is a 70% chance that demand will be poor, in which case the after-tax cash flows will be $0.5 million for 3 years. The project is riskier than the firm’s other projects, so it has a WACC of 15%. The firm will know if the project is successful after receiving first year’s cash flows. After receiving the first year’s cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t = 1, but it will be able to sell the assets related to the project for $2.25 million after taxes at t = 1. What is the expected NPV of the project if it cannot be abandoned? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Negative value should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to two decimal places.

Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. It is considering the introduction of a “weight loss” smoothie. The project would require a $4 million investment outlay today (t = 0). The after-tax cash flows would depend on whether the weight loss smoothie is well received by consumers. There is a 40% chance that demand will be good, in which case the project will produce after-tax cash flows of $2.5 million at the end of each of the next 3 years. There is a 60% chance that demand will be poor, in which case the after-tax cash flows will be $1 million for 3 years. The project is riskier than the firm’s other projects, so it has a WACC of 11%. The firm will know if the project is successful after receiving first year’s cash flows. After receiving the first year’s cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t = 1, but it will be able to sell the assets related to the project for $3.5 million after taxes at t = 1. What is the value of the abandonment option? Enter your answer in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to two decimal places.

Sunshine Smoothies Company (SSC) manufactures and distributes smoothies. It is considering the introduction of a “weight loss” smoothie. The project would require a $3 million investment outlay today (t = 0). The after-tax cash flows would depend on whether the weight loss smoothie is well received by consumers. There is a 40% chance that demand will be good, in which case the project will produce after-tax cash flows of $1 million at the end of each of the next 3 years. There is a 60% chance that demand will be poor, in which case the after-tax cash flows will be $0.5 million for 3 years. The project is riskier than the firm’s other projects, so it has a WACC of 9%. The firm will know if the project is successful after receiving first year’s cash flows. After receiving the first year’s cash flows it will have the option to abandon the project. If the firm decides to abandon the project the company will not receive any cash flows after t = 1, but it will be able to sell the assets related to the project for $2.5 million after taxes at t = 1. Would this abandonment option project be accepted?

Florida Seaside Oil Exploration Company is deciding whether to drill for oil off the northeast coast of Florida. The company estimates that the project would cost $4.32 million today. The firm estimates that once drilled, the oil will generate positive cash flows of $2.16 million a year at the end of each of the next four years. While the company is fairly confident about its cash flow forecast, it recognizes that if it waits two years, it would have more information about the local geology as well as the price of oil. Florida Seaside estimates that if it waits two years, the project would cost $4.94 million. Moreover, if it waits two years, there is a 55% chance that the cash flows would be $2.277 million a year for four years, and there is a 45% chance that the cash flows will be $1.292 million a year for four years. Assume that all cash flows are discounted at a 10% WACC. If the company chooses to drill today, what is the project’s net present value? Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. Do not round intermediate calculations. Round your answer to five decimal places.

Answer 1

PART A:

NPV = [-5 + (1/1.5) + (1/1.5^2) + (1/1.5^3) ] = -2.716 mn (in $)

PART B:

NPV = [-4 +(1+3.5)/1.11] = 0.054 mn (in $)

PART C:

NPV on not abandoning = [-3 + (1/1.09) + (1/1.09^2) + (1/1.09^3)] = -0.468 mn (in $)

NPV on abandoning = [-3 +(0.5+2.5)/1.09] = -0.247 mn (in $)

As the project value is more in abandoning (i.e less amount of loss) so it should be abandoned.

PATR D:

NPV if drilled today = [-4.32 + (2.16/1.1) + (2.16/1.1^2) + (2.16/1.1^3) + (2.16/1.1^4)] = 2.526 mn (in $)