We are examining a new project. We expect to sell 7,000 units per year at €60 net cash flow apiece for the next 10 years. In other words, the annual operating cash flow is projected to be €60 × 7,000 = €420,000. The relevant discount rate is 16 per cent, and the initial investment required is €1,800,000.

(a) What is the base-case NPV?

(b) After the first year, the project can be dismantled and sold for €1,400,000. If expected sales are revised based on the first year’s performance, when would it make sense to abandon the investment? In other words, at what level of expected sales would it make sense to abandon the project?

(c) Explain how the €1,400,000 abandonment value can be viewed as the opportunity cost of keeping the project in one year.

(d) Suppose you think it is likely that expected sales will be revised upward to 9,000 units if the first year is a success and revised downward to 4,000 units if the first year is not a success. If success and failure are equally likely, what is the NPV of the project?

Consider the possibility of abandonment in answering. What is the value of the option to abandon?