Question

Iridium has spent $3.5 billion over the past decade on a satellite system. It is currently deciding whether to spend an additional $350 million on the project. If it spends this money, it expects this outlay will finish the project and generate cash flow of $15 million per year for the next five years. A competitor has offered to buy the system as is for $450 million. What are the relevant cash flows? What should management do?

please show written work step by step please dont use computer

Answer 1

The relevant cash flows associated with the project are depicted below:

The management's decision should be based on an NPV analysis, wherein the cash flows generated upon investing a further $ 350 million is discounted at an appropriate cost of capital to t=0 and summed. The $ 350 million is subtracted from this sum to arrive at the net cash flow received upon following this path. The second option involves selling the satellite in its current state to a competitor for $ 450 million. Comparison of this $ 450 million to the first option's (first paths) net cash flow (NPV) and selecting the greater of the two is the correct approach to this problem.

The initial investment of $ 3.5 billion is sunk cost in this scenario as the same cannot be recouped by following either pathway.