Fnce 3010 Essay

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FNCE 3010 (Durham). HW 9 — real options 1. ABC Sporting Goods is examining a project to produce a new line of tennis rackets. The project is expected to sell 7000 units per year with a net cash flow of $60 per unit. The project will run for 10 years, the discount rate is 16%, and an initial investment of $2.1 million is required. The project has no salvage value at the end of 10 years. Ignore taxes. (a) What is the base case NPV? (b) Now, suppose that at the end of the first year, the project can be dismantled and sold for $1.4 million. At what level of sales would it make sense to abandon the project? (c) Suppose that sales turn out to be either 5000 units or 9000 units per year, each with probability 50%. The true scenario is discovered at the end of the first year. Taking the option to abandon into account, what is the project’s NPV? (d) What is the value of the option to abandon? Solution: (a) Using an initial cash flow of -2.1 million followed by 10 cash flows of 420,000 each and a discount rate of 16%, calculate NPV. You should get NPV = -$70,044.46. (b) Since the opportunity cost of continuing the project is 1.4 million and the project has 9 years left, use your calculator with n=9, R=16%, PV=−1.4 million and FV=0. Solve for the PMT. You should find PMT=303,915.48. At $60 per unit, this means the financial break-even at the end of year 1 is 5066. Below that level, the project should be terminated. (c) Low scenario: • Abandon: NPV (at t=1) = 1.4 + .3 = $1.7 million. • Continue: 10 cash flows of $300,000 each with R = 16% implies NPV (at t=1) = $1,681,963. They should abandon. High scenario: • Abandon: NPV (at t=1) = 1.4 + .54 = $1.94 million. • Continue: 10 cash flows of $540,000 each with R = 16% implies NPV (at t=1) = $3,027,534. They should continue. Expected NPV at time 0 = -2.1 + (.5*1.70 + .5*3.027534)/1.16 = -$62,270. (d) Even taking into account the option to

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