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You own a small manufacturing plant that currently generates revenues of $2 million per year.Next year,based upon a decision on a long-term government contract,your revenues will either increase by 20% or decrease by 25%,with equal probability,and stay at that level as long as you operate the plant.Other costs run $1.6 million per year.You can sell the plant at any time to a large conglomerate for $5 million and your cost of capital is 10%.
-If you are awarded the government contract and your sales increase by 20%,then the value of your plant will be closest to:
A)$5 million.
B)$8 million.
C)$0.
D)$4 million.

Question

Quizplus · Accepted Answer

We can calculate the value of the plant with and without the government contract to determine the best choice.

Without government contract:
Revenues = $2 million
Costs = $1.6 million
Profit = $400,000
Plant value = $5 million (sale price)
Cost of capital = 10%

Using the formula for discounted cash flows, we can calculate the present value of the plant:
PV = CF/(1+r)^n 
PV = (400,000/(1+0.1))^1 + (400,000/(1+0.1))^2 + ... (400,000/(1+0.1)^n) + 5,000,000/(1+0.1)^n
PV = 4,000,000

With government contract:
Revenues = $2.4 million (20% increase)
Costs = $1.6 million
Profit = $800,000
Plant value = ?
Cost of capital = 10%

Using the same formula, we can calculate the present value of the plant with the increased profits:
PV = CF/(1+r)^n 
PV = (800,000/(1+0.1))^1 + (800,000/(1+0.1))^2 + ... (800,000/(1+0.1)^n) + ?/(1+0.1)^n

To determine the plant value at this new level, we can use the formula for perpetuity:
PV = CF/r
PV = 800,000/0.1
PV = $8 million

Therefore, if awarded the government contract, the value of the plant will be $8 million, which is closest to answer choice B.

Use the Information for the Question(s)below