Consider the following project for Hand Clapper. The company is considering a 4-year project to manufacture clap-command garage door openers. This project requires an initial investment of €10 million that will be depreciated using the 20 per cent reducing balance method over the project’s life. The salvage value at the end of the project’s life is assumed to be equal to its residual or written-down value. An initial investment in net working capital of €3 million is required to support spare parts inventory; this cost is fully recoverable whenever the project ends. The company believes it can generate €8 million in pre-tax revenues with €2 million in total pre-tax operating costs.

The tax rate is 34 per cent, and the discount rate is 17 per cent. The market value of the equipment over the life of the project is as follows:

(a) Assuming Hand Clapper operates this project for 4 years, what is the NPV?

(b) Now compute the project NPVs assuming the project is abandoned after only 1 year, after 2 years and after 3 years. What economic life for this project maximizes its value to the firm? What does this problem tell you about not considering abandonment possibilities when evaluating projects?

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Year 1 234 3 Market value ( millions) 6.50 6.00 3.00 0.00