Question

Broadway Inc. is considering a new musical. The initial investment required is $880,000. Every year, the free cash flow from the project is expected to be $80,000, continuing forever (Hint: think about a perpetuity).

a. What is the NPV of the project?
b. In fact, the annual cash flow of $80,000 is an expected value: there is a 50% chance that annual cash flow will be $180,000 and a 50% chance that it will be -$20,000. What is the expected NPV of the project if the company cannot abandon the project?
c. What is the true NPV of the project if the company can abandon the project after the first year?
d. What is the value of the option to abandon?

Answer 1

Broadway Inc.

a. NPV of the project:

= $120,000 ($1,000,000 - 880,000)

b. Expected NPV of the project if the company cannot abandon the project:

= $120,000 ($1,000,000 - 880,000)

c. True NPV if the company can abandon the project after the first year:

= NPV = $74,080 - $880,000

= -$805,920

d. Value of the option to abandon:

= NPV = $74,080 - $880,000

= -$805,920

Step-by-step explanation:

a) Data and Calculations:

Initial investment cost = $880,000

Assumed cost of capital = 8%

Expected annual free cash inflow = $80,000 in perpetuity

NPV = PV of Cash inflows minus PV of Cash outflows

PV of a perpetuity = Expected Annual Cash Inflows divided by cost of capital

= $80,000/0.08

= $1,000,000

$80,000 * 0.926 = $74,080

NPV = $74,080 - $880,000

= -$805,920

b) Broadway's Present Value of its perpetual annual cash inflow is calculated by dividing the cash inflow by the rate of interest, which is the cost of capital.