Asked Mar 30, 2019

Brewster’s is considering a project with a 5-year life and an initial cost of $120,000. The discount rate for the project is 12 percent. The firm expects to sell 2,100 units a year at a cash flow per unit of $20. The firm will have the option to abandon this project after three years at which time it could sell the project for $50,000. At what level of sales should the firm be willing to abandon this project at the end of the third year?


Expert Answer

Step 1

The life of the project is 5 years. However, it can be abandoned at the end of 3 years for a sale value of $ 50,000. Two more years of project life would be left at this stage.

Let the level of sales be Q units. It would make sense to abandon the project at then end of 3 years if:

Sale value at the end of 3 years > PV of all the future sales in year 4 and 5

Step 2

Sale value at the end of year 3 = $ 50,000

Cash flows in year 4 and 5 each, C = 20 x Q

Discout rate = R  = 12%

And period left = N = 2

Step 3

Present value of cash flows in year 4 & 5 at the end of year 3 = Sum of PV of annuity C over 2 years at discount rate of 12% = C / R x [1 - (1 + R)-N] = 20Q/0.12 x [1 - (1 + 0.12)-2] = 33.80Q

It would make sen...

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