8/7/2019 Tutorial Answer Corporate Finance USM Chapter 7

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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: $ 5MCash Flow per year: $880K

Life of Project: 10

Discount Rate: 10%

b. Information after one yearUpward Sales Revision: $1,750,000Downward Sales Revision: $290,000After Tax Salvage Value: 1,300,000Probability of increased sales: 50%

Answers:

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

=

InvestmentInitialr

rCF

t

1

11

,

=

MK 5

%10

%101

11

880

10

= MK 51.0

385543.01880

= MK 5144567.6880 = 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 ornot. The detail and the conceptual to do this question are described on page 220

InvestmentInitial

r

rCF

t

1

11

8/7/2019 Tutorial Answer Corporate Finance USM Chapter 7

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%10

%101

11

290

9

K

759023816.5290K 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.

1.1

Pr FlowCashNewobability

1.1

91.116,670,1%50 = 759,144.05

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

1Present Value 1 year expected Cash Flow =1,1

000,880= 8000,000

2Expeected value today of downward revision =1.1

000,300,1%50 = 590,909.09

3Present Value of Upward Revision =

%10

%10111

000,750,1%50

9

=

%10

424097618.01875K = 759023816.5875K = 5,039,145.84. But you have to

present value it in one year. So,1.1

84.145,039,5= 4,581,041.67

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