Your firm is considering a project with a five-year life and an initial cost of $260,000. The discount rate for the project is 14 percent. The firm expects to sell 3,600 units a year. The cash flow per unit is $30. The firm will have the option to abandon this project after three years at which time they expect they could sell the project for $150,000. You are interested in knowing how the project will perform if the sales forecast for years four and five of the project are revised such that there is a 60/40 chance that the sales will be either 2,800 or 4,400 units a year, respectively. What is the net present value of this project given your sales forecasts?
A) $96,141
B) $114,715
C) $132,708
D) $141,414
E) $155,556

Question

Quizplus · Accepted Answer

First, calculate the annual cash flow: 3,600 units * $30 = $108,000 per year for the first three years. For years four and five, calculate the expected cash flow using the probabilities: (0.6 * 2,800 units + 0.4 * 4,400 units) * $30 = $100,800 expected cash flow per year. The NPV formula is used to calculate the present value of these cash flows and the option to abandon the project for $150,000 at the end of year three, all discounted at the 14% rate. The initial cost is subtracted from the sum of these present values to find the NPV.

Your Firm Is Considering a Project with a Five-Year Life