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Acme Co. is considering a four-year project that will require an initial investment of $5,000....

Question:

Acme Co. is considering a four-year project that will require an initial investment of $5,000. 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.

What would be the expected net present value (NPV) of this project if the project's cost of capital is 12%?

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 $4,000 (at the end of year 2). The $4,000 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.

Using the information in the preceding problem, find the expected NPV of this project when taking the abandonment option into account. What is the value of the option to abandon the project?

Expected Net Present Value

The expected net present value is an extension to NPV where it adjusts for the uncertainty of the occurrence of a particular scenario. It is the summation of the product of the NPV of a scenario and the probability of the occurrence of that scenario.

{eq}Expected NPV = \sum Scenario NPV x Probability {/eq}

Since the expected net present value accounts for the uncertainty of projected cash flows it is a more reliable measure compared to NPV.

Answer and Explanation:

To solve for the expected net present value of the project, we first need to solve for the NPV of each scenario (base, best and worst-case scenarios)....

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Net Present Value: Evaluating Estimates
Net Present Value: Evaluating Estimates

from Financial Accounting: Help and Review

Chapter 4 / Lesson 1
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