Bankers’ Services Inc. (BSI) is considering a project that has a cost of $10 million and an expected life of 3 years. There is a 30% probability of good conditions, in which case the project will provide a cash flow of $9 million at the end of each year for 3 years. There is a 40% probability of average conditions, in which case the annual cash flows will be $4.5 million, and there is a 30% probability of bad conditions and a cash flow of $1.5 million per year. BSI can, if it chooses, close down the project at the end of any year and sell the related assets for 90% of the book value. The asset sale price will be received at the end of the year the project is shut down. The related assets will be depreciated by the straight-line method over 3 years, and the value at the end of Year 3 is zero. (Don’t worry about IRS regulations for this problem.) BSI uses a 12% WACC to evaluate projects such as this one.
a. Find the project’s expected NPV with and without the abandonment option.
b. How sensitive is the NPV to changes in the company’s WACC? to the percentage of book value at which the asset can be sold?
c. Now assume that the project cannot be shut down. However, expertise gained by taking it on will lead to an opportunity at the end of Year 3 to undertake a venture that has the same cost as the original project and will be undertaken if the best-case scenario develops. If the project is wildly successful (the good conditions), the firm will go ahead with the project but will not go ahead with the other two scenarios (because consumer demand will still be considered too difficult to determine). As a result, the new project will generate the same cash flows as the original project in the best-case scenario. In other words, there will be a second $10 million cost at the end of Year 3 and then cash flows of $9 million for the following 3 years. Also, this new project cannot be abandoned if it is undertaken. How does this new information affect the original project’s expected NPV? At what WACC will the project break even in the sense that NPV = $0?
d. Now suppose the original (no abandonment) project can be delayed a year. All of the cash flows remain unchanged, but information obtained during that year will tell the company exactly which set of demand conditions exist. How does this option to delay the project affect its NPV?