Question

Nippon Inc is considering a project that has an up-front cost of $500,000. The project’s subsequent cash flows depend on whether its products become the industry standard. There is a 60% chance that products will become the industry standard, in which case the project’s expected cash flows will be $120,000 per year for the next 7 years. There is a 40% chance that products will not become the industry standard, in which case the project’s expected cash flows will be $60,000 a year for the next 7 years. Assume the cost of capital is 8%.

a.) Calculate NPV of the project.

b.) Assume that 3 years from now, Nippon will know if its product will have become the industry standard. The firm has the option to abandon the project after receiving the cash flows at t = 3, and the abandonment option does not affect the cost of capital. If the firm decides to abandon the project, it will receive additional $350,000 at t = 3, but will no longer receive any cash flows after that. What is the estimated value of the abandonment option?

Answer 1

a)

	Become Industry standard	Doesn't become Industry standard
Years	Cash Flows	Cash Flows
0	-500000	-500000
1	120000	60000
2	120000	60000
3	120000	60000
4	120000	60000
5	120000	60000
6	120000	60000
7	120000	60000
NPV	124764	-80000
NPV of the project	42859

b)

	Become Industry standard	Doesn't become Industry standard
Years	Cash Flows	Cash Flows
0	-500000	-500000
1	120000	60000
2	120000	60000
3	120000	410000
4	120000	0
5	120000	0
6	120000	0
7	120000	0
NPV	124764	30000
NPV of the project	86859

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