Question

Bradford 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 percent 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 percent probability of medium conditions, in which case the annual cash flows will be $4 million, and there is a 30 percent probability of bad conditions and a cash flow of -$1 million per year. BSI uses a 12 percent cost of capital to evaluate projects like this.

Required:
a. Find the project's expected cash flows and NPV.
b. Now suppose the BSI can abandon the project at the end of the first year by selling it for $6 million. BSI will still receive the Year 1 cash flows, but will receive no cash flows in subsequent years. Assume the salvage value is risky and should be discounted at the WACC.

Answer 1

a) expected cash flow per year (same for all 3 years) = (30% x $9 million) + (40% x $4 million) + (30% x -$1 million) = $4 million

initial outlay = $10 million

discount rate = 12%

NPV = -$10 + $4/1.12 + $4/1.12² + $4/1.12³ = -$0.39 million

b) assuming that the project is abandoned at the end of year 1:

NPV = -$10 + $4/1.12 + $6/1.12 = -$1.07 million

Actually things get worse if you decide to sell the project after year 1. The present value of the expected cash flows is higher than the present value of the salvage value.