Question 29 asks about the decision to abandon.

Before deciding it, question 29a asks the

NPV first. The point b asks the decision. The given information from the passage is:

a. Initial Investment: $ 5M
Cash Flow per year: $880K
Life of Project: 10
Discount Rate: 10%

b. Information after one year

Upward Sales Revision: $1,750,000
Downward Sales Revision: $290,000
After Tax Salvage Value: 1,300,000
Probability of increased sales: 50%

Answers:

a. It is a straightforward question. So, plug in the information to NPV formula.

 1 
1  1  r t 
= CF    Initial Investment ,
 r 
 
 
 1 
1  1  10% 10 
= 880 K    5M
 10% 
 
 
1  0.385543 
= 880 K 
 0.1   5M
= 880K 6.144567 5M
= 5,407,219.05 – 5,000,000
= 407,219.05

b. First, find out the downward revision of Cash Flow to decide continue the project or
not. The detail and the conceptual to do this question are described on page 220
 1 
1  1  r t 
CF    Initial Investment
 r 
 
 
  1 
1  1  10% 9 
290 K  
 10% 
 
 
290K 5.759023816
1,670,116.91
If the sales are revised downward, the company would continue the project as it is
higher than 1,300,000

However, if the cash flow is only 1,670,116.91, company should decide whether the
project is still profitable in the future or not. Therefore, the company should find out
the present value of the Cash Flow to make a decision.

Pr obability  New Cash Flow

1.1
50% 1,670,116.91
= 759,144.05
1.1

Now, we can see the PV of the new cash flow after the downward revision is smaller
than 1,300,000. Therefore, we should ABANDON the project.

If we abandon the project, how much will we gain?

Revised NPV = (1Present Value 1 year expected Cash Flow + 2Expeected value today
of downward revision + 3Present Value of Upward Revision) – Initial Investment

1 880,000
Present Value 1 year expected Cash Flow = = 8000,000
1,1
2 50% 1,300,000
Expeected value today of downward revision = = 590,909.09
1.1

 1 
1 
 1  10% 9 
3
Present Value of Upward Revision = 50%  1,750,000  =
 10% 
 
 
1  0.424097618 
875K 
 10%  = 875K 5.759023816 = 5,039,145.84. But you have to
5,039,145.84
present value it in one year. So, = 4,581,041.67
1.1

Revised NPV = (800,000 + 590,909.09 + 4,581,041) – 5,000,000 = 971,950.76