Acme Co. is considering a four-year project that will require an initial investment of $9,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $21,000 per year, and the worst-case cash flows are projected to be –$2,500 per year. The company’s analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows. A. What would be the expected net present value (NPV) of this project if the project’s cost of capital is 11%? $27,066 $29,773 $28,419 $23,006 Acme now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,500 (at the end of year 2). The $4,500 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project’s assets and the company’s –$2,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project. B. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account. $27,887 $35,226 $33,758 $29,355 C. What is the value of the option to abandon the project ?

Principles of Accounting Volume 2

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ISBN:9781947172609

Author:OpenStax

Publisher:OpenStax

Chapter11: Capital Budgeting Decisions

Section: Chapter Questions

Problem 2PB: Markoff Products is considering two competing projects, but only one will be selected. Project A...

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8. Abandonment options

Acme Co. is considering a four-year project that will require an initial investment of $9,000. The base-case cash flows for this project are projected to be $14,000 per year. The best-case cash flows are projected to be $21,000 per year, and the worst-case cash flows are projected to be –$2,500 per year. The company’s analysts have estimated that there is a 50% probability that the project will generate the base-case cash flows. The analysts also think that there is a 25% probability of the project generating the best-case cash flows and a 25% probability of the project generating the worst-case cash flows.

A. What would be the expected net present value (NPV) of this project if the project’s cost of capital is 11%?

$27,066

$29,773

$28,419

$23,006

Acme now wants to take into account its ability to abandon the project at the end of year 2 if the project ends up generating the worst-case scenario cash flows. If it decides to abandon the project at the end of year 2, the company will receive a one-time net cash inflow of $4,500 (at the end of year 2). The $4,500 the company receives at the end of year 2 is the difference between the cash the company receives from selling off the project’s assets and the company’s –$2,500 cash outflow from operations. Additionally, if it abandons the project, the company will have no cash flows in years 3 and 4 of the project.

B. Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account.

$27,887

$35,226

$33,758

$29,355

C. What is the value of the option to abandon the project ?

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