Real Options—the Option to Abandon a Project You and several of your classmates havejust graduated from college and are evaluating various investment opportunities, including a startupcompany that would produce high-quality jackets embroidered with a college logo. If demand forthis customized product is high, you expect to sell approximately 100,000 units per year, at a priceper unit of $80. On the other hand, because of stiff competition in the field, a pessimistic estimateis that demand for your new product would be only 40,000 units per year at a selling price of$70. Anticipated variable costs per jacket amount to $40. Capacity-related (i.e., short-term fixed)costs other than the cost of manufacturing equipment are thought to be negligible. Manufacturingequipment (with a 10-year life, a cost of $12 million, and a zero salvage value) would have to bepurchased as part of this project. Assume that, for income tax purposes, your company will usestraight-line depreciation over the life of the proposed investment. Your anticipated income taxbracket for this endeavor is 33 _13%. You are unsure of what discount rate to use for capital budgetingpurposes, but you believe the appropriate rate is somewhere between 10% and 14% on an after-taxbasis.Required1. What is the anticipated after-tax cash flow for this investment for each of the two possible states ofnature/scenarios? Round both answers to the nearest whole dollar.2. Under the assumption that the two scenarios (level of product demand) are equally likely, what is theexpected NPV of the proposed investment, rounded to the nearest whole dollar? Assume a discount rateof 12%. Based on the amount you estimated, should you invest in the project?3. How sensitive is your decision to the assumption regarding the discount rate? To answer this question,prepare an estimated NPV for the proposed project using discount rates, in 1% increments, from 10% to14% (Round all answers to the nearest whole dollar.) Is the decision to accept or reject the investmentsensitive to the discount rate used in the calculation of NPV?4. Suppose your company could abandon the project and dispose of the manufacturing equipment for$10.4 million if demand for your product turns out to be weak. You and your colleagues would makethis decision at the end of the first year of operations. What is the expected NPV of the proposed project,with the abandonment option? (Use a discount rate of 12%; round your final answer to nearest wholedollar.) Comment on the value of the abandonment option in this example.
Real Options—the Option to Abandon a Project You and several of your classmates have
just graduated from college and are evaluating various investment opportunities, including a startup
company that would produce high-quality jackets embroidered with a college logo. If demand for
this customized product is high, you expect to sell approximately 100,000 units per year, at a price
per unit of $80. On the other hand, because of stiff competition in the field, a pessimistic estimate
is that demand for your new product would be only 40,000 units per year at a selling price of
$70. Anticipated variable costs per jacket amount to $40. Capacity-related (i.e., short-term fixed)
costs other than the cost of manufacturing equipment are thought to be negligible. Manufacturing
equipment (with a 10-year life, a cost of $12 million, and a zero salvage value) would have to be
purchased as part of this project. Assume that, for income tax purposes, your company will use
straight-line
bracket for this endeavor is 33 _1
3%. You are unsure of what discount rate to use for capital budgeting
purposes, but you believe the appropriate rate is somewhere between 10% and 14% on an after-tax
basis.
Required
1. What is the anticipated after-tax cash flow for this investment for each of the two possible states of
nature/scenarios? Round both answers to the nearest whole dollar.
2. Under the assumption that the two scenarios (level of product demand) are equally likely, what is the
expected NPV of the proposed investment, rounded to the nearest whole dollar? Assume a discount rate
of 12%. Based on the amount you estimated, should you invest in the project?
3. How sensitive is your decision to the assumption regarding the discount rate? To answer this question,
prepare an estimated NPV for the proposed project using discount rates, in 1% increments, from 10% to
14% (Round all answers to the nearest whole dollar.) Is the decision to accept or reject the investment
sensitive to the discount rate used in the calculation of NPV?
4. Suppose your company could abandon the project and dispose of the manufacturing equipment for
$10.4 million if demand for your product turns out to be weak. You and your colleagues would make
this decision at the end of the first year of operations. What is the expected NPV of the proposed project,
with the abandonment option? (Use a discount rate of 12%; round your final answer to nearest whole
dollar.) Comment on the value of the abandonment option in this example.
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