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  • 1.  DCF Analysis

    Posted 02-18-2020 05:48 AM
    Kindly explain the working for below problem:

    A company is evaluating the possible introduction of a new version of an existing product that will have a 2-year life cycle. At the end of 2 years, this version will be obsolete, with no additional cash flows or salvage value. The initial and sole outlay for the modified product is $6 million, and the company's desired rate of return is 10%. Following are the potential cash flows (assumed to occur at the end of each year) and their probabilities if the product is marketed:

    The following interest factors for the present value of $1 at 10% are relevant:

    Period  1
    .909
    2
    .826
     
    Question: 71 Assume the company has the real option to abandon the project at the end of Year 1. If the salvage value at that time is $3 million and the desired rate of return remains at 10%, what is the project's net present value?
    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.


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    Shilpa Sinha
    Analyst
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