CMA Study Group

Dear Members 

Please help me to explain the working of below question



------------------------------
Shilpa Sinha
Analyst
------------------------------

​Hi Shilpa,

Please find below:-
'000s

Initial Investment     $ 6,000

Cash inflows at the end of Year 1 - 
              Probability    Cash Inflow    Amount
Scenario 1  30%             2,000            600
             S2  40%             4,000           1,600
             S3  30%             6,000           1,800
Total cash inflow at the end of Year 1 : 600+1600+1800 = 4000
NPV = 4000 x .909 = 3,636

Cash inflows at the end of Year 1 -
Probability      Cash Inflow    Amount
S1 30%*50%            0                    0
      30%*50%         4,000           600
S2 40 %*25%         6,400           640
      40%*75%         3,200           960
S3 30 %*40%         6,875           825
      30%*60%         5,000           900
Total cash inflow at the end of Year 2 : 600+640+960+825+900 = 3925
NPV = 4000 x .826 = 3242.05

Project's NPV: Initial Investment - Discounted Cashflows for Yr1 & Yr2
= (6000)+3636+3242.05 = 878.5

------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates
------------------------------

Original Message:
Sent: 02-22-2020 04:01 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Members

Please help me to explain the working of below question

------------------------------
Shilpa Sinha
Analyst
------------------------------

Dear Mary,

Thanks for the explanation. Actually there is part 2 in this question that I missed to post earlier. I have doubt about the below question
Assume the company has a real option to abandon the project at the end of year 1 if the salvage value at that time is $3M and the desired rate of return remains 10% , what is the project's NPV?

Correct ans being $1,200,550

------------------------------
Shilpa Sinha
Analyst
------------------------------

Original Message:
Sent: 02-22-2020 04:20 AM
From: Mary Mitzel Claire Susa
Subject: Cash flow analysis

​Hi Shilpa,

Please find below:-
'000s

Initial Investment     $ 6,000

Cash inflows at the end of Year 1 -
              Probability    Cash Inflow    Amount
Scenario 1  30%             2,000            600
             S2  40%             4,000           1,600
             S3  30%             6,000           1,800
Total cash inflow at the end of Year 1 : 600+1600+1800 = 4000
NPV = 4000 x .909 = 3,636

Cash inflows at the end of Year 1 -
Probability      Cash Inflow    Amount
S1 30%*50%            0                    0
      30%*50%         4,000           600
S2 40 %*25%         6,400           640
      40%*75%         3,200           960
S3 30 %*40%         6,875           825
      30%*60%         5,000           900
Total cash inflow at the end of Year 2 : 600+640+960+825+900 = 3925
NPV = 4000 x .826 = 3242.05

Project's NPV: Initial Investment - Discounted Cashflows for Yr1 & Yr2
= (6000)+3636+3242.05 = 878.5

------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates

Original Message:
Sent: 02-22-2020 04:01 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Members

Please help me to explain the working of below question

------------------------------
Shilpa Sinha
Analyst
------------------------------

​Hi Shilpa,

I actually read the explanation of the correct answer, which is below:-

Answer (B) is correct. 
If the cash flows at the end of Year 1 equal $2 million, the expected value of the Year 2 cash flows is only $2 million [(.5 × $0) + (.5 × $4 million)]. If the cash flows at the end of year 1 equal $4 million or $6 million, the expected value of the Year 2 cash flows equals $4 million [(.25 × $6.4 million) + (.75 × $3.2 million)] or $5.75 million [(.4 × $6.875 million) + (.6 × $5 million)], respectively. After discounting these expected values to the end of Year 1, the present values are $1,818,000 (.909 × $2 million) given a $2 million Year 1 cash flow, $3,636,000 (.909 × $4 million) given a $4 million Year 1 cash flow, and $5,226,750 (.909 × $5.75 million) given a $6 million Year 1 cash flow. Accordingly, the real option of abandonment is preferable if the Year 1 cash flow is $2 million. The $3 million salvage value exceeds the expected value of the Year 2 cash flows discounted to the end of Year 1 in this case only. If the real option of abandonment is exercised only when Year 1 cash flows equal $2 million, the expected value of the cash flows at the end of Year 1 is $4.9 million {[.3 × ($2 million + $3 million salvage)] + (.4 × $4 million) + (.3 × $6 million)}, and the present value of this amount is $4,454,100 (.909 × $4.9 million). The expected value of the cash flows at the end of Year 2 if the real option is exercised only when Year 1 cash flows equal $2 million is $3,325,000 (.3 × 1.0 × $0) + (.4 × .25 × $6.4 million) + (.4 × .75 × $3.2 million) + (.3 × .4 × $6.875 million) + (.3 × .6 × $5 million), and the present value of this amount is $2,746,450 (.826 × $3,325,000). Consequently, the NPV with an abandonment option is $1,200,550 ($4,454,100 + $2,746,450 – $6 million initial outlay). This amount is substantially greater than the NPV with no abandonment option.

However, I actually find it rather confusing as well. Because if the project will be ceased then its means that there should no more cash flow in Yr 2, right?

While checking the explanation again, I am not sure if I am correct but it mentioned"If the real option of abandonment is exercised only when Year 1 cash flows equal $2 million" .

Since, only Scenario 1 has a lesser cash flow value than the salvage value, thus there is only 30% chance to abandon the project and only Scenario 1 was assumed to be abandoned. So 3M was added to the cash inflow of Scenario 1 for yr1 while its yr2 was zero.
Scenario 2 and 3 was assumed the project will not be abandoned because it has a greater value that the salvage value and company will not decide to abandon the project if it less than the salvage value.

Again, I am not 100% sure if my opinion is correct, if anyone has a better or correct explanation. Please give us your insight.

Regards,
Mary Mitzel



------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates
------------------------------

Original Message:
Sent: 02-22-2020 06:13 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Mary,

Thanks for the explanation. Actually there is part 2 in this question that I missed to post earlier. I have doubt about the below question
Assume the company has a real option to abandon the project at the end of year 1 if the salvage value at that time is $3M and the desired rate of return remains 10% , what is the project's NPV?

Correct ans being $1,200,550

------------------------------
Shilpa Sinha
Analyst

Original Message:
Sent: 02-22-2020 04:20 AM
From: Mary Mitzel Claire Susa
Subject: Cash flow analysis

​Hi Shilpa,

Please find below:-
'000s

Initial Investment     $ 6,000

Cash inflows at the end of Year 1 -
              Probability    Cash Inflow    Amount
Scenario 1  30%             2,000            600
             S2  40%             4,000           1,600
             S3  30%             6,000           1,800
Total cash inflow at the end of Year 1 : 600+1600+1800 = 4000
NPV = 4000 x .909 = 3,636

Cash inflows at the end of Year 1 -
Probability      Cash Inflow    Amount
S1 30%*50%            0                    0
      30%*50%         4,000           600
S2 40 %*25%         6,400           640
      40%*75%         3,200           960
S3 30 %*40%         6,875           825
      30%*60%         5,000           900
Total cash inflow at the end of Year 2 : 600+640+960+825+900 = 3925
NPV = 4000 x .826 = 3242.05

Project's NPV: Initial Investment - Discounted Cashflows for Yr1 & Yr2
= (6000)+3636+3242.05 = 878.5

------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates

Original Message:
Sent: 02-22-2020 04:01 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Members

Please help me to explain the working of below question

------------------------------
Shilpa Sinha
Analyst
------------------------------

Dear Mary,

Thanks for the reply.  I have convinced my self with the same logic as you as mentioned in the answer provided. With the option to abandon, only scenario 1 will be abandoned and Scenario 1 and 2 will remain as it is to calculate CF for the project.

------------------------------
Shilpa Sinha
Analyst
------------------------------

Original Message:
Sent: 02-22-2020 07:01 AM
From: Mary Mitzel Claire Susa
Subject: Cash flow analysis

​Hi Shilpa,

I actually read the explanation of the correct answer, which is below:-

Answer (B) is correct. 
If the cash flows at the end of Year 1 equal $2 million, the expected value of the Year 2 cash flows is only $2 million [(.5 × $0) + (.5 × $4 million)]. If the cash flows at the end of year 1 equal $4 million or $6 million, the expected value of the Year 2 cash flows equals $4 million [(.25 × $6.4 million) + (.75 × $3.2 million)] or $5.75 million [(.4 × $6.875 million) + (.6 × $5 million)], respectively. After discounting these expected values to the end of Year 1, the present values are $1,818,000 (.909 × $2 million) given a $2 million Year 1 cash flow, $3,636,000 (.909 × $4 million) given a $4 million Year 1 cash flow, and $5,226,750 (.909 × $5.75 million) given a $6 million Year 1 cash flow. Accordingly, the real option of abandonment is preferable if the Year 1 cash flow is $2 million. The $3 million salvage value exceeds the expected value of the Year 2 cash flows discounted to the end of Year 1 in this case only. If the real option of abandonment is exercised only when Year 1 cash flows equal $2 million, the expected value of the cash flows at the end of Year 1 is $4.9 million {[.3 × ($2 million + $3 million salvage)] + (.4 × $4 million) + (.3 × $6 million)}, and the present value of this amount is $4,454,100 (.909 × $4.9 million). The expected value of the cash flows at the end of Year 2 if the real option is exercised only when Year 1 cash flows equal $2 million is $3,325,000 (.3 × 1.0 × $0) + (.4 × .25 × $6.4 million) + (.4 × .75 × $3.2 million) + (.3 × .4 × $6.875 million) + (.3 × .6 × $5 million), and the present value of this amount is $2,746,450 (.826 × $3,325,000). Consequently, the NPV with an abandonment option is $1,200,550 ($4,454,100 + $2,746,450 – $6 million initial outlay). This amount is substantially greater than the NPV with no abandonment option.

However, I actually find it rather confusing as well. Because if the project will be ceased then its means that there should no more cash flow in Yr 2, right?

While checking the explanation again, I am not sure if I am correct but it mentioned"If the real option of abandonment is exercised only when Year 1 cash flows equal $2 million" .

Since, only Scenario 1 has a lesser cash flow value than the salvage value, thus there is only 30% chance to abandon the project and only Scenario 1 was assumed to be abandoned. So 3M was added to the cash inflow of Scenario 1 for yr1 while its yr2 was zero.
Scenario 2 and 3 was assumed the project will not be abandoned because it has a greater value that the salvage value and company will not decide to abandon the project if it less than the salvage value.

Again, I am not 100% sure if my opinion is correct, if anyone has a better or correct explanation. Please give us your insight.

Regards,
Mary Mitzel



------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates

Original Message:
Sent: 02-22-2020 06:13 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Mary,

Thanks for the explanation. Actually there is part 2 in this question that I missed to post earlier. I have doubt about the below question
Assume the company has a real option to abandon the project at the end of year 1 if the salvage value at that time is $3M and the desired rate of return remains 10% , what is the project's NPV?

Correct ans being $1,200,550

------------------------------
Shilpa Sinha
Analyst

Original Message:
Sent: 02-22-2020 04:20 AM
From: Mary Mitzel Claire Susa
Subject: Cash flow analysis

​Hi Shilpa,

Please find below:-
'000s

Initial Investment     $ 6,000

Cash inflows at the end of Year 1 -
              Probability    Cash Inflow    Amount
Scenario 1  30%             2,000            600
             S2  40%             4,000           1,600
             S3  30%             6,000           1,800
Total cash inflow at the end of Year 1 : 600+1600+1800 = 4000
NPV = 4000 x .909 = 3,636

Cash inflows at the end of Year 1 -
Probability      Cash Inflow    Amount
S1 30%*50%            0                    0
      30%*50%         4,000           600
S2 40 %*25%         6,400           640
      40%*75%         3,200           960
S3 30 %*40%         6,875           825
      30%*60%         5,000           900
Total cash inflow at the end of Year 2 : 600+640+960+825+900 = 3925
NPV = 4000 x .826 = 3242.05

Project's NPV: Initial Investment - Discounted Cashflows for Yr1 & Yr2
= (6000)+3636+3242.05 = 878.5

------------------------------
Mary Mitzel Claire Susa
Accountant
Dubai
United Arab Emirates

Original Message:
Sent: 02-22-2020 04:01 AM
From: Shilpa Sinha
Subject: Cash flow analysis

Dear Members

Please help me to explain the working of below question

------------------------------
Shilpa Sinha
Analyst
------------------------------

Original Message------

Dear Members 

Please help me to explain the working of below question

------------------------------
Shilpa Sinha
Analyst
------------------------------