Buffalo Drumsticks is evaluating a proposal to open a restaurant in Bermuda.The restaurant will cost $29 million to open.Expected cash flows are $8 million per year for the first five years.At the end of 5 years,the government of Bermuda will either revoke BD's permit and the restaurant will close,or renew the permit indefinitely.If the permit is revoked,the building and equipment can be sold for $10,000,000.If the permit is renewed,assume that the $8 million turns into a perpetuity.There is a 30% chance the permit will be revoked and a 70% chance it will be renewed.Compute the expected NPV of the project.Use a discount rate of 12%.

Question

Quizplus · Accepted Answer

To calculate the expected NPV of the project, we need to find the present value of all the cash flows and terminal value and then subtract the initial investment.

PV of cash flows for the first 5 years = $8 million x annuity factor of 5 years at a discount rate of 12% = $8 million x 3.6048 = $28.84 million

Terminal value if the permit is revoked = $10 million

PV of perpetuity if the permit is renewed = $8 million / 0.12 = $66.67 million

Expected terminal value = $10 million x 0.3 + $66.67 million x 0.7 = $52.67 million

Expected NPV = PV of cash flows + expected terminal value - initial investment
= $28.84 million + $52.67 million - $29 million
= $52.51 million - $29 million
= $23.51 million

Therefore, the expected NPV of the project is $23.51 million, which is closest to option C ($28.02 million).

Buffalo Drumsticks Is Evaluating a Proposal to Open a Restaurant