Margerit is reviewing a project with projected sales of 1,500 units a year,a cash flow of $40 a unit and a three-year project life.The initial cost of the project is $95,000.The relevant discount rate is 15 percent.Margerit has the option to abandon the project after one year at which time she feels she could sell the project for $70,000.At what level of sales should she be willing to abandon the project?

Question

Quizplus · Accepted Answer

To determine the level of sales at which Margerit should be willing to abandon the project, we need to compare the present value of the expected cash flows for the next two years with and without the abandonment option.

Without abandonment option:
PV of expected cash flows for year one and two = 1500*40*(1-(1+15%)^-2)/15% = $83,878.85
Initial cost = $95,000
Net present value (NPV) = $83,878.85 - $95,000 = -$11,121.15

With abandonment option:
PV of expected cash flow for year one = 1500*40*(1-(1+15%)^-1)/15% = $51,724.14
Expected sale price after year one = $70,000
PV of expected cash flow if project is abandoned after year one = $51,724.14 + $70,000/(1+15%) = $112,029.68
Initial cost = $95,000
NPV = $112,029.68 - $95,000 = $17,029.68

Therefore, Margerit should be willing to abandon the project if the level of sales is less than the breakeven point where NPV = $0:
$11,121.15/(1+15%) + $17,029.68/(1+15%)^2 + X*40*(1-(1+15%)^-2)/15% = $70,000/(1+15%)
Solving for X, we get X = 1,077 units.

Margerit Is Reviewing a Project with Projected Sales of 1,500