Question

9.14 Options and NPV What is the option to abandon? The option to expand? Explain why we tend to underestimate NPV when we ignore these options?

14. Project Evaluation Kolby’s Korndogs is looking at a new sausage system with an installed cost of $655,000. This cost will be depreciated straightline to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $85,000. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 22 percent and the discount rate is 8 percent, what is the NPV of this project?

Answer 1

1. When investing in new projects, firms worry about the risk that the investment will not pay off, and that actual cash flows will not be as per the projections. Hence while entering into the contract, firms may prefer to have the option to abandon a project that does not pay-off. This option can can be valuable, especially on projects with high gestation period, uncertain cash-flows and a significant potential for losses. This is option to abandon. On the contrary, firms sometimes may invest cautiously with an option to make follow-on investment in future or to enter other markets in the future. Such an option enables the firm to make additional investment in future after considering the changes in riskiness as the project goes along. This is option to expand. When we ignore these options, we tend to underestimate the NPV because we tend to consider higher discount rate. E.g. if a firm has option to expand in future, it may accept a negative net present value on the initial project because of the possibility of high positive net present values on future projects. However in absence of such option, it may tend to take a conservative stand and apply a much higher risk premium despite high potential payoff in future. When a firm has an option to expand an investment, the value of this expansion option may sometimes allow it to override the fact that the initial investment has a negative net present value. Similarly since option to abandon reduces the firm’s exposure to the worst outcomes, it can make the difference between investing in a new project and not investing. In absence of this option, it will always take a conservative stand and tend to assume higher discount rate.
2. Annual Depreciation = 655,000 / 5 = $131,000
   After-Tax Salvage Value to Zero = Salvage value * (1 - Tax rate) = 85,000*(1 - 0.22) = $66,300. It is assumed that the working capital is not recouped. NPV will be as follows:

Year	1	2	3	4	5
Pretax operating savings	$183,000	$183,000	$183,000	$183,000	$183,000
Depreciation	$131,000	$131,000	$131,000	$131,000	$131,000
Tax	$11,440	$11,440	$11,440	$11,440	$11,440
Net profit	$40,560	$40,560	$40,560	$40,560	$40,560
Depreciation	$131,000	$131,000	$131,000	$131,000	$131,000
Operating Cash Flow	$171,560	$171,560	$171,560	$171,560	$171,560
OCF	$171,560	$171,560	$171,560	$171,560	$171,560
PV of OCF (OCF / (1 + 8%)^n)	$158,852	$147,085	$136,190	$126,102	$116,761
Total of PV of OCF	$684,989
Plus PV of Post-tax Salvage Value (66300 / (1+ 8%)^5)	$45,123
Less Capex	-$655,000
Less WC Investment	-$35,000
NPV	$40,112

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